Body and Wings: Introduction to the Butterfly Options Spread Strategy

Learn more about the concept of butterfly options spreads, how they are different from iron condors, and an explanation of a butterfly options strategy.
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Key Takeaways

  • A butterfly options spread is similar to an iron condor but with a couple key differences
  • A butterfly can help you profit if a stock hits your target price within a certain time frame
  • Learn the maximum risks and potential gains of a butterfly spread

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

Newly minted option 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 option traders understand that an iron condor is a combination of two short out-of-the-money (OTM) vertical spreads: one call spread and one put spread. It’s a high-probability, nondirectional trade for range-bound markets. 

The following, like all 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 options strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.

What is a butterfly spread?

A butterfly spread is 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.

Comparing these winged creatures: Butterfly vs. iron condor

Remember, an iron condor is a combination of both a short 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.

FIGURE 1: SHORT IRON CONDOR. This four-legged, winged creature is designed for range-bound markets. For illustrative purposes only. Past performance does not guarantee future results.

The butterfly is also a combination of two vertical spreads. But while 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.

FIGURE 2: LONG CALL BUTTERFLY. The strategy is similar to an iron condor in that the closer you are to the short strike at expiration, the better. For illustrative purposes only. Past performance does not guarantee future results.

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.

Let’s say we’re looking at a stock that’s trading at $43.75, and we think the stock is going stay put or drift up to $44 over the next month and a half. Buying a 42 call and selling the 44 call as a spread (the “42-44 call spread” in trader lingo) in an expiration date that’s about six weeks out is a neutral-to-bullish trade that’s worth its maximum value if the stock moves to $44 or higher at expiration. 

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 (see figure 3).

How to create a butterfly spread

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 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 use 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

FIGURE 3: RISK GRAPH OF THE 42-44-46 CALL BUTTERFLY. If you pay $0.65 for the butterfly, that would be the maximum loss if the stock falls below $42 or rises above $46 per share. The maximum theoretical profit is at the 44 strike. For illustrative purposes only. Past performance does not guarantee future results.

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 $65 ($0.65 x 100). 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 short OTM 44-46 call spread would expire worthless. And because you paid $0.65 for the spread, your net profit before transaction costs would be $135 [($2 – $0.65) x 100].

A final word on iron condors and butterfly options 

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. Traders may consider implementing butterflies if they have OTM strikes around earnings season or anytime they might expect a stock to move quickly into a range and then sit there.  

For example, suppose a stock is trading at $100 per 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.

Compared to other options strategies, 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: to maximize the return from a butterfly a trader must not only pinpoint a 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. 


Key Takeaways

  • A butterfly options spread is similar to an iron condor but with a couple key differences
  • A butterfly can help you profit if a stock hits your target price within a certain time frame
  • Learn the maximum risks and potential gains of a butterfly spread

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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.

Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

Spreads, straddles, and other multiple-leg options strategies can entail additional transaction costs, including multiple contract fees, which may impact any potential return. These are advanced options strategies and often involve greater risk, and more complex risk, than basic options trades.

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