How would you like to earn a positive return if you think a stock is going to stay flat or swing wildly in either direction over the short term? If so, then you should check out the butterfly spread.

A butterfly spread is a multi-leg options strategy that involves either a short or a long position.

If you go short, then you’re anticipating the underlying stock to swing up or down in price in the near future.

If you go long, then you’re anticipating the underlying stock price to stay flat in the near future.

In either case, it’s a limited risk, limited profit strategy.

In this guide, I’ll explain the butterfly spread so you can make an informed decision about using it in your options trades.

What Is a Butterfly Spread?

A butterfly spread involves opening four trades: two of them are buys and two of them are sells.

If you’re opening a long butterfly position, you’ll buy one out-of-the-money option, sell two at-the-money options, and buy one in-the-money option. In that case, you make money when the price of the underlying stock stays roughly the same.

If you’re opening a short butterfly position, you’ll do the exact opposite: sell one out-of-the-money option, buy two at-the-money options, and sell one in-the-money option. In that case, you make money when the price of the underlying stock goes above the higher strike price or below the lower strike price.

You can structure a butterfly spread with call options or put options. It works the same either way as long as all the options in the trade are the same. In other words, they must all be call options or all put options.

Another important point: the in-the-money and out-of-the-money options must be equidistant in strike price from the at-the-money option.

For example, if you buy two $60 at-the-money call options for a short spread, then you can keep the butterfly in balance by selling the $55 in-the-money call option and $65 out-of-the money call option. That’s because both of those options are exactly $5 away from the $60 strike price of the at-the-money options.

When Would You Use a Butterfly Spread?

Use a butterfly spread when you think the price of the underlying stock is going to stay flat or swing significantly in either direction.

If you think the stock is going to stay flat, opt for a long butterfly spread.

If you think the stock is going to move up or down by a wide margin, opt for a short butterfly spread.

It’s also worth noting that a butterfly spread is a complicated strategy that’s best suited for experienced traders. If you’re just getting started out, make sure you do plenty of practice trading with butterfly spreads before you start working with real money.

Read Also: How does a long call options spread work?

How Does a Butterfly Spread Work?

Before you can enter into a butterfly spread, make sure that your trading platform supports multi-leg orders. Don’t even think about trying a butterfly spread without that ability. You could lose a lot of money.

Once you’ve established that your online brokerage supports multi-leg trades, it’s easy to place the order.

First, determine whether you’re going long or short with the butterfly spread. See above for info on that.

If you’re going long:

• Buy an out-of-the-money option
• Sell two at-the-money options
• Buy an in the money option

If you’re going short:

• Sell an out-of-the-money option
• Buy two at-the-money options
• Sell an in-the-money option

After you’ve established your trading direction, open the appropriate positions one at a time. Make sure you review your whole trade before you finally “pull the trigger.” Mistakes in options trading can be very expensive.

A long transaction will result in a debit to your account (meaning you’ll pay for it). A short transaction will result in a credit to your account (meaning you’ll receive money).

Read Also: What are the best stock options screeners?

Real Life Example Using a Butterfly Spread?

Let’s say that Bank of America is trading at $28.50 per share. You think it’s going to stay flat over the next month, so you decide to open a long butterfly spread.

You start by buying next month’s $26 call option for $2.64. That costs you $264 since options contracts trade in groups of 100 shares ($2.64 x 100).

Next, you sell two at-the-money call options. They’re currently trading for $0.74 each, so that earns you $148 ($0.74 x 2 x 100).

Finally, you buy the $31 call option for $0.07. That costs you only $7 ($.07 x 100).

So your total debit for the whole transaction is $264 – $148 + $7 = $123. That’s also your maximum loss for this butterfly spread.

Let’s assume your prediction was accurate. During the course of the next month, Bank of America shares hover around $28.50. What happens?

You win.

Remember, the whole point of a long butterfly spread is to profit when the stock price doesn’t move much.

If Bank of America is near $28.50 as you move close to expiration, the in-the-money call options will drop a bit in price to around $2.20.

However, the at-the-money options will decrease in value to $.10 per contract from the original price of $0.74 per contract. That’s okay, though, because you were short those options. You want them to go down in value.

The out-of the money call option will expire worthless.

Let’s run the numbers: You lost $0.44 on the in-the-money option ($2.64 – $2.20). You made $1.28 on the at-the-money options ($0.74 – $0.10 x 2). You lost $0.07 on the out-of-the-money option.

So your total profit for the trade is $1.28 – $0.44 – $0.07 or $0.77.

Remember, though, that options contracts trade in groups of 100 shares so your profit is really $77 ($0.77 x 100).

 

What Are Similar Strategies Related to Butterfly Spread?

Here are a couple of strategies similar to a butterfly spread:

• Neutral Calendar Spread – Involves buying long-term call options while selling the same amount of near-term at-the-money or slightly out-of-the-money call options.
• Iron Condor – Involves buying an out-of-the-money call option, selling an out-of-the-money call option at a lower strike price, buying an out-of-the-money put option, and selling an out-of-the-money put option at a higher strike price.Click here to read more about Iron Condors.

Butterfly Spread Compared to Other Options Strategies?

A butterfly spread is a limited-risk, limited-profit strategy. As such, it joins countless other options strategies that use spreads to mitigate both risk and profit.

Keep in mind, though: when you’re dealing with “limited” risk or profit in options trading, you can still earn a high return or lose a lot of money relative to the amount you invest.

That’s because options use leverage.

Advantages & Risks of Butterfly Spread?

Advantages

• Limited risk – You can’t lose any more than you invest in a long butterfly spread. If you open a short butterfly spread, your maximum loss is limited to the difference between the upper and lower strike prices minus the premium you received when you opened the position.
• Profit from neutrality or volatility – Butterfly spreads give you the option to make money when the underlying stock is bouncing all around or if it’s staying relatively flat.

Risks

• Limited profit – Although you can make some nice returns with butterfly spread, you can’t “let your winners run.” That’s because your profit is capped.
• Significant percentage loss possible – You can still lose a significant amount of money, on a percentage basis, relative to what you invest in a butterfly spread trade. Make sure you do plenty of practice trading before opening a “real” butterfly spread.