Body and Wings: Introduction to the Option Butterfly Spread

What has three legs and flies, especially during range-bound markets? A butterfly option spread. Read on if you’ve not heard this one before.

Newly minted options traders often explore single-leg strategies first, such as buying or selling a put or call option. Next might come buying and selling vertical spreads. Both of these basic strategies offer directional exposure. Think of them as the caterpillar stage.

Metamorphosis: Moving up to more complex spreads, more experienced options traders understand that an iron condor is just a combination of two short out-of-the-money vertical spreads–one call spread and one put spread. It’s a high-probability, non-directional trade for markets that may be range-bound. 

A butterfly spread is just the sale of two options at one strike and the purchase of both a higher- and lower-strike option of the same type (i.e., calls or puts). And if you understand how the iron condor works, then you’ll see that buying a butterfly is similar in principle to selling an iron condor.

The following, like all of our strategy discussions, is strictly for educational purposes. It is not, and should not be considered, individualized advice or a recommendation. Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. 

Comparing These Winged Creatures

Remember, an iron condor is a combination of both a short out-of-the-money (OTM) put spread and a short OTM call spread. The combined premium from both short vertical spreads is the maximum potential profit. But because only one spread can be in the money at expiration, the risk is the width of the spread minus the combined premiums. As long as the underlying doesn’t move much and both spreads remain OTM through expiration, all is well.

The butterfly is also just a combination of two vertical spreads. But where the iron condor is made up of one call spread and one put spread, the butterfly is made up of either two call spreads or two put spreads.

And instead of looking for both OTM spreads to expire worthless, the butterfly wants one spread to go out worthless, and one spread to be worth its full value. Here’s how it works.

But suppose we don’t think the stock is going to move much higher than $44. With that view, we might consider selling the 44 call and buying the 46 call as a spread (the “44-46 call spread”), which is a bearish trade whose max profit is realized if the stock stays below $44 through expiration. Put the two trades together and you have a multi-legged spread with the potential for max profit if the stock closes right by $44 by expiration, as shown in figure 3.

Doing the Math

This combination of long and short vertical call (or put) spreads is a butterfly. The neat thing is that the premium from the short vertical helps to offset the cost of the long vertical, netting out a lower premium paid and therefore a lower risk. But it’s worth noting that multi-leg spreads will incur more transaction costs than single-leg options which will impact any potential returns.

For the sake of simplicity, let’s assume the following transaction prices not including commissions (each near mid-market per the bid/ask in figure 3):

• Buy a 42-strike call at $2.25
• Sell two 44-strike calls at $0.91 each
• Buy a 46 call at $0.22

With these prices, the 42-44 call spread would cost $1.34, but selling the 44-46 call spread would bring in $0.69, for a total cost of $0.65 for the butterfly (plus transaction costs), and that’s your maximum risk. If the stock drops below $42, or jumps above $46 at or before expiration, you’ll hit the maximum loss.

Remember, the multiplier for most standard listed U.S. equity options is 100. So, in dollar terms, the spread costs ($0.65 x 100) = $65. And let’s not forget about transaction costs. Multi-leg spreads generally mean larger transaction costs, including multiple commissions.

If the stock closes right at $44 at expiration, you would hit the maximum profit, which is the difference between the strikes, minus what you paid, plus transaction costs. In this case, the long in-the-money 42-44 call spread would be worth the full $2, and the short out-of-the-money 44-46 call spread would expire worthless. And since you paid $0.65 for the spread, your net profit before transaction costs would ($2 - $0.65) x 100 = $135.

A Final Word on Butterflies and Iron Condors

Butterfly spreads, whether calls or puts, tend to expand slowly in price, even if the underlying is right at the ideal short strike, until you get to the week of expiration. Then, they generally begin to expand more rapidly as you get closer to expiration and the underlying is near the midpoint. Butterflies, especially those with out-of-the-money strikes, can come in handy around earnings season, or anytime you might expect a stock to move quickly into a range and then sit there.

For example, suppose a stock is trading at $100 a share, and you expect an earnings surprise that will take it to $110. Buying a butterfly with 110 as the middle strike, say the 105-110-115 call butterfly, can be a capital-efficient way to take advantage of an anticipated move. Of course, if the stock stays below $105, or if a surprise upside move takes it above $115, you’ll lose the premium you paid for the spread, plus transaction costs.

Sometimes, a butterfly is inexpensive at initiation, especially if the underlying is far from the midpoint. Some traders would say they’re cheap for a reason, which is that maximizing the return from a butterfly requires not only a pinpoint target in the stock price, but also pinpoint timing.

Iron condors and butterflies are sort of in the same family, and have similar risk profiles. They’re both made from a combination of two verticals, and both can be used when you expect a stock to stay within a certain range.