What is a Butterfly Option Spread?

Butterfly spreads are one of my favorite strategies to use in volatile or choppy markets when you are expecting a specific price zone to be hit and implied volatility to drop. This is common to use for a catalyst like earnings reports so you can isolate a potential zone where you can target price to move towards and also benefit from implied volatility (IV) collapsing. The goal of the butterfly is to profit from neutral stock price action near the strike price of the short options (center strike) while still having limited risk since you pay a net debit. The best part about profiting from butterfly spreads is that you can benefit from prices hanging out in a wide range and not just if the stock goes to point A in a straight line. The term “butterfly” in the strategy name is thought to have originated from the profit-loss diagram. The peak in the middle of the diagram of a long butterfly spread looks vaguely like the body of a butterfly, and the horizontal lines stretching out above the highest strike and below the lowest strike look vaguely like the wings of a butterfly.

A typical standard long butterfly consists of 3 strikes being used and is created by buying one call at a lower strike price, selling two calls with a higher strike price and buying one call with an even higher strike price. All calls have the same expiration date, and the strike prices are equidistant. There are several different variations of butterfly’s I like to use including the broken wing fly and the unbalanced fly but for this post I will focus on the basic butterfly.

The strategy is created for a net debit as both the potential profit and max risk are limited. You can really structure a butterfly any way you want to fit your assumption on the stock. Assuming you are using a liquid stock or index which is preferred since it’s a 3 legged spread strategy. I usually only recommend a butterfly on a stock that trades a lot of volume and has weekly options available since that is a clear sign of liquidity for a stock. You want to be able to enter and exit the butterfly spread at fair prices as close to the mid price of the spread as possible to avoid slippage. The other thing to consider when entering a butterfly is if the risk/reward ratio is favorable. Generally you want a butterfly to have a nice payoff potential so say if you paid $2.50 on a 10 point wide butterfly then that’s a solid 1 to 4 risk/reward since the cost you are paying is $2.50 and the butterfly could expand as high as $10. That would result in a profit of $7.50 per spread. 

Maximum profit and risk

The max profit potential is equal to the difference between the lowest and middle strike prices minus the net debit cost for the trade. This max profit is only realized if the stock “pins” or closes at the center strike price at expiration. Since this is quite rare and unrealistic it’s best to have more reasonable profit targets on a butterfly like for example doubling your money on a spread you bought at 2.50 going to 5.00. The max risk is always the net debit paid for the spread. This loss is realized if the stock closes below the lowest strike of the butterfly at expiration or completely above the highest strike. So you can see you are trying to have a big enough fishing net to “catch the butterfly” so to speak. Having too narrow of a width in a butterfly won’t allow for much of a chance of that range being realized. In general, the wider the butterfly spread the higher the probability of profit but also the higher the net cost you will pay.

In the example below using TSLA stock I constructed a 50 point wide call butterfly using February options with 14 days of life. With the stock trading at 923, if we thought TSLA would go higher towards 1000 in the next few weeks but didn’t know exactly when we could buy a butterfly that profits between 950 and 1050 for a small debit of $7.75. The max this butterfly can be worth is $50.00 at expiration if it closes right at 1000. Buying one of the 950 calls, selling two of the 1000 calls, and buying one of the 1050 calls creates the butterfly spread. You put this trade on all at once simultaneously as a spread to get the best theoretical fill price. 

As you can see just $775 per spread allows us to participate in the short term upside of TSLA stock. You can of course use a small width or larger width for the butterfly which changes the cost. It just comes down to what expected range you see unfolding for the stock in the timeframe you are using. This is often best determined based on the options market implied moves and delta for each strike. In this example I utilized the 1000 call strike as the center strike as it’s a round number with lots of open interest and has a delta of 25. That means it’s within the expected move range for the expiration date of February 18th. If you were more neutral on TSLA you could do an at the money butterfly which would benefit most if the stock stayed flat and IV dropped. 

Breakevens and Expiration

The risk profile graph below shows a nice visual of the butterfly spread entered on February 4th with the blue line showing profit and loss at expiration while the pink line showing current day PnL. This is the kind of trade you put on if anticipating a slower grind or choppy move towards a price range. The trade benefits from time passing (theta) and also implied volatility (vega) dropping. The closer we get to the expiration date the more the pink line will morph into the blue line as prices change and the butterfly (hopefully) expands. 

At expiration the breakeven for this butterfly will be equal to the lowest strike price plus the cost of the position (7.75) so with 950 being our lower strike price we add 950 + 7.75 and get a breakeven at expiration of 957.75. The same on the upside breakeven we have 1050 as the upper strike price so we take 1050 – 7.75 and get a breakeven at expiration of 1042.25. Assuming we waited to close the spread until expiration day we would profit if TSLA stock is anywhere between 957.75 and 1042.25 with the center 1000 strike being the “sweet spot” of the butterfly.

As the second risk graph below shows the same butterfly trade but with time moved forward to Feb 15th (3 days before expiration) the spread has expanded nicely and the pink line has inflated higher showing a solid profit if the stock is anywhere between 950-1050. You can see if the stock is at 1000 on this day assuming all else is equal, the profit on the butterfly is now $882, which means it has more than doubled from our entry cost of $775. This is the power of butterflies because since you sold two of the center strike options you benefit from all the extrinsic value or theta decay melting away each day that gets closer to expiration. It’s also a risk the closer to expiration you hold the spread because gamma increases quickly as you approach expiration. If the stock moved violently one day or gapped overnight too far out of our range we are trying to “trap the butterfly within” then our profits can vanish quickly. For this reason I usually like to exit butterfly trades several days before expiration if the stock is somewhere near the center of the range. 

When to Use a Butterfly Option Strategy

A long butterfly spread is a great strategy when a trader anticipates the stock price to be near the center strike price of the spread since the butterfly profits from time decay. You can use a call butterfly spread for a move to the upside while a put butterfly spread would be used for a move to the downside. In both cases the butterfly is best for a modest move unfolding in a slower fashion or in a volatile market with already high implied volatility that the trader expects to decline. Since long butterfly spreads are sensitive to changes in implied volatility many traders will buy butterflies when they expect IV to fall. As you might expect this is a fantastic way to trade earnings reports because the collapse in volatility which is common after earnings reports will then benefit the butterfly spread buyer. Profit potential is high and risk is always limited to the net debit paid. The key to trading earnings butterfly spreads is giving yourself enough of a wide range or “net” for the butterfly to be caught.

If volatility does not contract then the price of the butterfly does not move as quickly in your favor unless you are very close to the expiration date since at the time it has the smallest amount of extrinsic value. Patience is required when trading butterflies because the primary way the trade expands higher in price is through time passing and volatility falling. The stock movement helps but is not the only factor. Since the stock price can move within a large range and frequently move past the center strike during the course of the trade, this is a trade that requires patience and less watching. Disciplined plans are also good to have in this type of trade because the previously mentioned gamma risk that enters the closer to expiration we get. A trader needs to be disciplined to have profit targets in mind and not go for the homerun waiting to hold until the final day. Taking partial profits and scaling out of multiple butterfly spreads is ideal as it goes in your favor and also having loss thresholds to obey if the stock gets too far out of the profit range and the probability of success fades.

Takeaways:

• A long butterfly consists of 3 strikes being used and is created using the same expiration dates.
• Butterfly spreads benefit from theta decay or time passing and also contracting implied volatility.
• The closer to expiration day you hold the butterfly the more theta decay that occurs but also the more gamma risk that appears.
• Butterflies have a max risk of the net debit that you paid.
• Using this strategy into events like earnings reports is a great way to isolate risk to a specific amount while expecting a certain price range to be targeted.