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Butterfly Spread
The long butterfly spread is a three-leg strategy that is appropriate
for a neutral forecast – when you expect the underlying stock price (or
index level) to change very little over the life of the options. A
butterfly can be implemented using either call or put options. For
simplicity, the following explanation discusses the strategy using call
options.
A long call butterfly spread consists of three legs with a total of
four options: long one call with a lower strike, short two calls with a
middle strike and long one call of a higher strike. All the calls have the
same expiration, and the middle strike is halfway between the lower and
the higher strikes. The position is considered "long" because it
requires a net cash outlay to initiate.
When a butterfly spread is implemented properly, the potential gain is
higher than the potential loss, but both the potential gain and loss will
be limited.
The total cost of a long butterfly spread is calculated by multiplying
the net debit (cost) of the strategy by the number of shares each contract
represents. A butterfly will break-even at expiration if the price of the
underlying is equal to one of two values. The first break-even value is
calculated by adding the net debit to the lowest strike price. The second
break-even value is calculated by subtracting the net debit from the
highest strike price. The maximum profit potential of a long butterfly is
calculated by subtracting the net debit from the difference between the
middle and lower strike prices. The maximum risk is limited to the net
debit paid for the position.
Butterfly spreads achieve their maxim profit potential at expiration if
the price of the underlying is equal to the middle strike price. The
maximum loss is realized when the price of the underlying is below the
lowest strike or above the highest strike at expiration.
As with all advanced option strategies, butterfly spreads can be broken
down into less complex components. The long call butterfly spread has two
parts, a bull call spread and a bear call spread.
A long butterfly spread is used by investors who forecast a narrow
trading range for the underlying security. The long butterfly is a
strategy that takes advantage of the time premium erosion of an option
contract, but still allows the investor to have a limited and known risk.
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