What Is a Butterfly Spread?

By Markets Fool.com

There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.

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A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.

A butterfly spread is a neutral strategy where the trader does not think the stock will move very much. Here's how it works.

The basic setup

A butterfly is a combination of a bull spread and a bear spread that have an overlapping middle strike price. The strategy consists of buying an out-of-the-money (OTM) call above the current stock price, buying an in-the-money (ITM) call below the current stock price, and selling two at-the-money (ATM) calls near the current stock price. You can also use all puts if you choose.

A related variant of the butterfly spread is the iron butterfly, which uses a combination of calls and puts instead of just calls or just puts. The butterfly and the iron butterfly are strategically similar.

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For example, if a stock was trading at $50 and you wanted to establish a butterfly, you could buy a $45 call, sell two $50 calls, and buy a $55 call. Let's say the $45 call is trading at $7, the $50 call is trading at $3, and the $55 call is trading at $1. The net debit for this trade would be $2.

Maximum gain: difference between middle and lower strike prices minus net debit

A butterfly has limited profit potential. The most that you can make on a butterfly is the difference between the middle and lower strike prices minus the net debit. If the stock stays flat, which is the goal of this strategy, the bullish call spread will realize its own maximum gain, while the bearish call spread expires worthless (but it helped offset the cost of the trade by bringing in premiums). The maximum gain is realized if the stock closes upon expiration at exactly the middle strike price.

In this example, if the stock closed at $50 upon expiration, the bullish call spread would be exercised. You would purchase the stock at $45, then sell it at $50 for a $5 gain. The remaining $50 call would expire worthless, as would the $55 call. Then you would subtract out the net debit of $2 paid in premium for a total gain of $3.

Maximum loss: net debit

Butterfly spreads also have limited risk. The most that you can lose on a butterfly is the net premium paid. This occurs if the stock does not stay flat and increases or decreases beyond the upper or lower strike prices. The maximum loss is realized if the stock closes upon expiration below the lower strike or above the upper strike.

In this example, if the stock closed below $45, then all call contracts would expire worthless and you would lose the $2 in net debit. Conversely, if the stock closed above $55, then the bullish call spread would realize its maximum gain of $5 (buy at $45, sell at $50), but then bearish call spread would simultaneously realize its maximum loss of $5 (buy at $55, sell at $50) to exactly offset that gain, while you still lose the $2 in net debit.

Breakeven: higher strike minus net debit or lower strike plus net debit

Butterfly spreads have two breakeven points since there are two spreads involved. The breakeven points are the higher strike price minus the net debit, or the lower strike plus the net debit.

In this example, if the stock closed at $47 (lower strike plus net debit), then the bullish call spread would have a value of $2, which exactly offsets the $2 net debit, while the bearish call spread expires worthless. If the stock closed at $53 (higher strike minus net debit), the bullish call spread would be worth $5, the bearish call spread would lose $3, and you subtract out the $2 net debit to break even.

The article What Is a Butterfly Spread? originally appeared on Fool.com.

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