Long Butterfly Spreads: Finding Good Candidates

Key Points

  • Long butterfly spreads are a neutral strategy generally used when you expect the underlying stock (or ETF) to remain in a narrow range.
  • Consider securities that are range-bound, trading near the price of standard options strike prices, and are unlikely to be in the news in the near term. 
  • We review how to set up a butterfly spread. 

A long butterfly spread is a neutral, three-legged strategy. It is generally used when you expect the underlying security to remain in a narrow trading range over the life of the options.

The butterfly spread strategy involves three different strike prices established in a 1/2/1 ratio; it can be built with either calls or puts and while it is primarily a neutral strategy, it will typically have a very slight bullish or bearish bias.

When you are researching potential stocks (or ETFs) to create your butterfly spread, good contenders usually have similar criteria:

  • Range bound: They have been in a five- to 15-point channel (trading range) for about six to eight weeks or more.
  • Trading in the middle of the range: They have been trading in the middle of that channel.
  • Trading near a standard option strike price: They are trading near a standard option strike price, such as 15, 20, 22.50, 25, 27.50, 30, etc.
  • No news: They are not expected to be in the news (e.g., an earnings report), which might cause the security to move out of that channel, or spur a sharp increase in volatility.

While these criteria might sound overly restrictive, you’ll be surprised how many candidates you’ll find through a little research. Then, it is often helpful to draw the important price levels of a potential strategy on a price chart, such as those available in StreetSmart Edge®. This will help you not only visualize potential profits but also stock price movements that may result in an unprofitable strategy.

How to calculate price levels

First, let’s learn how to calculate key price levels through a sample two-point butterfly spread. Assuming stock XYZ is trading at $33.91, the following formulas will allow you to calculate the maximum gain, maximum loss, and upper and lower breakeven prices on any butterfly trade.

Example of a two-point butterfly spread:

Buy 10 XYZ Aug 32 calls @ 2.29
Sell 20 XYZ Aug 34 calls @ .88
Buy 10 XYZ Aug 36 calls @ .29
Debit = .82 (-2.29 + [2x.88] - .29)
Maximum gain = 1.18 (second strike - first strike - debit) (occurs at second strike) or $1,180
Maximum loss = .82 (debit paid) (occurs at outside strike prices) or $820
Upper breakeven = $35.18 (second strike + maximum gain) 
Lower breakeven = $32.82 (second strike – maximum gain) 
Total cost of this trade = $820 (debit x number of spreads x option multiplier) or (.82 x 10 x 100)

Or, you can simply allow StreetSmart Edge to do so as shown below.

Calculating maximum gain, maximum loss and breakeven for a butterfly trade

Calculating maximum gain, maximum loss and breakeven for a butterfly trade

Once you know these important values, consider drawing them on the actual price chart to visualize it. This will help determine whether the trade is potentially realistic or not.

Creating charts

To create charts, you'll want to include lines that are the outside strike prices of 32 and 36 (maximum loss levels) and the upper and lower breakeven levels of $35.18 and $32.82. A convenient way to do this is to use the support and resistance lines, which are typically used for technical analysis, to illustrate the breakeven and maximum loss levels. Use the support line tool (red line) for the outer maximum loss lines, and the resistance line tool (green line) for the breakeven thresholds as illustrated below.

Breakeven thresholds

Breakeven thresholds

This chart was taken around July 10, 2014 with the August butterfly having about 37 days until expiration. It illustrates that if XYZ is between $32.82 and $35.18 at the August option expiration, this trade will be profitable. The maximum profit of $1,180 will be reached if XYZ is exactly $34 at expiration.

However, you’ll incur losses if XYZ closes above $35.18 at expiration, with a maximum $820 loss occurring at any price above $36. This will also happen if XYZ closes below $32.82 at expiration, with an $820 maximum loss also coming at any price below $32.

As with most butterfly spreads, it is very unlikely that the stock will close exactly at the maximum profit price of $34. However, with a profit zone of 2.36 points ($35.18 – $32.82), this candidate has a little room for normal market fluctuation, and could finish profitable if it remains fairly stable until the options expire.

If the trade is profitable, the rate of return can be calculated by dividing the amount of the eventual gain ($0 up to $1,180) by the amount invested ($820). Thus, your rate of return will be somewhere between 0% and 144%. If the trade is unprofitable, the loss will range from 0% to 100%.

Butterfly candidates with other profit and loss characteristics

Let’s review one more example to illustrate a good five-point butterfly candidate with different profit and loss levels. Assume stock ZYX is trading at $187.73.

ZYX has the following characteristics:

  • Range bound: It has been in a 10-point channel between about $180 and $190 for about six weeks.
  • Trading in the middle of the range: It has been trading around the middle of that channel ($187.73) with a price near the standard option strike price of 185.
  • No news: There’s no expected news or impending events (e.g., an earnings report), which might cause the security to move out of that channel, or spur a sharp increase in volatility.

Example of a five-point butterfly spread:

Buy 5 ZYX Apr 180 calls @ 9.55
Sell 10 ZYX Apr 185 calls @ 5.75
Buy 5 ZYX Apr 190 calls @ 3.25
Debit = 1.30 (-9.55 + [2 x 5.75] – 3.25)
Maximum gain = 3.70 (second strike – first strike - debit) (occurs at second strike) or $1,850
Maximum loss = 1.30 (debit paid) (occurs at outside strike prices) or $650
Upper breakeven = $188.70 (second strike + maximum gain) 
Lower breakeven = $181.30 (second strike – maximum gain) 
Total cost of this trade = $650 (debit x number of spreads x option multiplier) or (1.30 x 5 x 100)

Again, these formulas will allow you to calculate the maximum gain, maximum loss, and upper and lower breakeven on any butterfly trade, or you can simply allow StreetSmart Edge to do it for you as shown below.

How to calculate maximum gain, maximum loss and breakeven in StreetSmart Edge

How to calculate maximum gain, maximum loss and breakeven in StreetSmart Edge

Once you have these important values, consider drawing them on the actual price chart to visualize and help determine whether the trade is realistic or not.

For this example, the lines you’ll want to show on the chart are the outside strike prices of $180 and $190 (represented by the red lines) and the upper and lower breakeven levels of $188.70 and $181.30 (represented by the green lines). As in the previous example, I’ve used the support and resistance line tools to mark up the following chart.

Price chart 

Price chart 

This chart was taken around July 10, 2014 as the August butterfly had about 37 days until expiration. If ZYX is between $188.70 and $181.30 at the August option expiration, this trade will be profitable. The maximum $1,850 profit will be reached if ZYX is at exactly $185 at expiration.

You’ll incur losses if ZYX closes above $188.70 at expiration, with the maximum $650 loss occurring at any price above $190. Likewise, losses will be incurred if ZYX closes below $181.30 at expiration, with the maximum $650 loss also occurring at any price below $180.

Keep in mind, it is very unlikely that the stock will close exactly at the maximum profit price of $185 but with a profit zone of 7.40 points ($188.70 – $181.30), this candidate has a fair amount of room for normal market fluctuation, and could finish profitable if it remains fairly stable until the options expire. If the trade does finish profitable, its profit will be between $0 and $1,850, with a rate of return somewhere between 0% and 285%. If the trade is unprofitable, the loss will range from 0% to 100%.

As discussed, with only a little effort, you will probably be very surprised at how many good butterfly spread candidates you’ll find.

I hope this enhanced your understanding of butterfly spread candidates. I welcome your feedback—clicking on the thumbs up or thumbs down icons at the bottom of the page will allow you to contribute your thoughts. (If you are logged into Schwab.com, you can include comments in the Editor’s Feedback box.)

Next Steps

Talk to Us
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Important Disclosures