In the field of financial markets, you need to apply various strategies to make money. There are and were great scholars who have made such strategies to make you win in your bet in this market. If you are not good at calculations and building your strategies, no worries, you can always rely on the existing one, as they have a proven success record.
Today we are going to talk about one such strategy used by the investors in the market, known as a butterfly spread. The term butterfly spread strategy is an options strategy that contains both bear and bull spreads. It has a fixed risk and a fixed profit. The butterfly strategy involves 4 calls, 4 puts, or the combination of calls and puts having three strike prices.
As we are aware that options are financial instruments having a value of an underlying asset, this asset could be a stock or a commodity. With the help of options contracts, the buyer can either buy or sell the underlying asset on the contract expiry date.
In the butterfly spread strategy, the buyer got four options having the same expiry with three different strike prices.
A higher strike price
An ATM - (At-The-Money) strike price
A lower strike price
The options which are at the higher and lower strike price will be at an equal distance from the ATM option. Suppose, ATM is at Rs. 50, then the higher and lower strike price will be at equal intervals from the ATM, here the lower and higher strike price would be Rs.45 and Rs.55, respectively.
There are in total 4 puts and calls options, and when we make different combinations from them, we get different designs, and each design can earn you profit.
Now, when we make combinations out of calls and put options we get different types of Butterfly Spread in Options Trading. Let's go through them first and then we shall also see Butterfly Spread Strategy Example, for better understanding.
Long Call Butterfly spread:
When an investor buys 1 in the money call option at a low strike price, 2 at the money call options, and 1 out of the money call option at a higher price than this combination is called a long call butterfly spread.
An investor can achieve the highest profit if the written price remains the same till the time of expiration. The profit can be gained by deducting the strike price of the lower call, premium and commission paid from the written option, and if there is a loss it will be only the premium and commission paid at the initial level.
Short Call Butterfly Spread:
When an investor sells one in-the-money option at a lower strike price, purchases two at-the-money call options, and sells off one out-of-the-money call option at the upper strike price, this combination is said to be the short butterfly spread strategy.
An investor gets the highest profit if the strike price has crossed the upper strike price or has come down lower than the lower-strike price at the time of contract expiry.
The highest profit will be gained by deducting the commission from the initial premium received.
Long put Butterfly spread:
When an investor buys one put at a lower strike price, sells 2 puts at the money, and buys 1 put with a higher strike price, this combination can be said as a long put Butterfly Spread Strategy. When the strike price remains in the middle option then an investor can get the highest profit.
The highest profit would be gained by deducting the price of the sold put and the premium from the higher strike price. The loss here would be premiums and commissions paid.
Short put Butterfly spread:
When an investor writes 1 out of the money put option at a low strike price, buys 2 at the money puts and writes 1 in the money put option at a higher strike price, then this combination can be said as a short put butterfly spread strategy. An Investor gains the highest profit when the price of the underlying asset is either above the upper strike value or below the lower strike value at the time of expiry.
There are some more combinations too like Iron butterfly and reverse iron butterfly spread. In which 2 call and 2 put options are bought and sold to make maximum profit.
Let us now check Butterfly Spread Strategy Example:
Assume that ABC stocks are traded at Rs.70. Now an investor thinks that the price of this ABC stock is not going to change for a major time. (Consider a few months). He chose a combination of the long call butterfly spread strategy, as it will give him a higher return if there is no change in the price. This investor now writes two call options on ABC stock at Rs.70 and buys two calls at the price of Rs.65 and Rs.75.
In the above case, the investor can make a huge profit, if the price of the ABC stock remains constant at Rs.70 at the time of expiry. If the strike price goes below Rs.65, or above Rs.75, then he faces a huge loss, in the form of buying the two call options.
There are other costs involved, like the premium paid. Let us say, if the strike price is between Rs.65 to Rs.75, investors may get some profit. Here the key thing to understand is the cost paid as the premium. Assume an investor has paid Rs. 2.50 to enter into the contract, and then he has to deduct this Rs.2.50 from the profit he might have earned, as this is the cost. So, considering or adding the cost amount, the new upper and lower strike prices would be Rs. 67.5 and Rs.72.50.
So, this was all about the Butterfly Strategy In Options Trading, we have seen in this article, what is Butterfly Spread Strategy also Butterfly Spread Strategy Example and what are the types of Butterfly Spread In Options. Hope we have been successful in making you understand the concept of the butterfly spread strategy used in the financial market by the option traders.