Long Butterfly Spreads: Understanding the Basics

Key Points

  • A long butterfly spread is a neutral strategy—appropriate when you expect the underlying security to remain in a narrow trading range over the life of the options.
  • It’s a three-legged strategy involving three different strike prices established in a 1/2/1 ratio.
  • It can be built with either calls or puts and have a slight bullish or slight bearish bias.
  • We look at how you might select strike prices for a long butterfly spread.

When derivatives traders discuss "exotic" option strategies, one strategy that is often mentioned is a butterfly. A long butterfly is a very unique strategy because it has a limited loss potential in either direction, and a profit zone lies between the two. It is a neutral strategy that is appropriate when you expect the underlying security not to move significantly over the life of the options.

While it sounds complicated (and might even look so pictured on a graph), it is fairly easy to understand. A long call (put) butterfly spread is a three-leg strategy with three different strike prices:

  • Buy one call (put) with a lower strike price,
  • Sell two calls (puts) with a middle strike price
  • Buy one call (put) with a higher strike price.

The options all have the same expiration date. Also, note that the middle strike price is halfway between the lower and the higher strikes. The position is considered "long" because a net cash outlay is required to initiate it. Like many option strategies, the maximum gain, maximum loss, and breakeven points are all known at the point of order entry.

When butterfly spreads were first introduced, there was very little demand from retail option traders primarily due to the high commission costs. Furthermore, since a long butterfly typically generates only modest profits relative to the risks involved, it was therefore initially better suited to institutional traders. But with options commissions declining over the years, including about a 75% fall at Schwab over the last 15 years, retail interest has steadily increased for this strategy.

When to open a butterfly order

The ideal time to enter a butterfly order is often when you expect very little movement in the underlying instrument (stock or ETF), and it is trading very near the middle strike price. Let’s take a look at a sample butterfly trade.

Purpose:  Limited risk with limited profit potential

Long call butterfly spread:

Buy to open 10 XYZ Dec 55 Calls @ 6.00A    

Sell to open 20 XYZ Dec 60 Calls @ 1.50B

Buy to open 10 XYZ Dec 65 Calls @ .50A

Note that a butterfly spread is always established in a 1/2/1 ratio. At Schwab, you get a discount on commissions when you enter multi-legged option strategies such as spreads, straddles, butterflies, condors, etc. as a single order, rather than as multiple smaller orders.

When you set up an order like this, StreetSmart Edge® automatically calculates the market price of this 10/20/10 spread. To do so manually, reduce the spread by its greatest common factor of 10 to 1/2/1 and then multiply each leg by the market price, using the ask price on the legs you are buying, and the bid price on the leg you are selling:

1 x -6A       =   -6.00

2 x +1.50B =   +3.00

1 x -.50A    =     -.50

Net                = -3.50 x 10 spreads = ($3,500) total up front cost

The market price of this butterfly spread is a net debit of 3.50, and the total cost would be 3.50 x the number of 1/2/1 spreads (10) x the option multiplier (100) = $3,500. 

Below is a chart depicting the profit/loss zones of this example, including the breakeven points, at the option expiration date.

Profit and loss profile for a long butterfly spread

Profit and loss profile for a long butterfly spread

Source: Schwab Center for Financial Research

The maximum profit on this strategy, which occurs only at the middle strike price of exactly 60 at expiration, is $1,500. Two breakeven points sit at 58.50 and 61.50 and all prices below 58.50 or above 61.50 result in a loss. The maximum loss to the upside or downside is -$3,500.

A look at different expiration price scenarios

To get a better feel for the profit and loss zones, see these sample prices at expiration.

XYZ at 55 or below at expiration:


Initial cost:                                                         ($3,500)
All options expire worthless:                              -0-
Net loss of 3.50 X 10 spreads:                        = ($3,500)

XYZ at 58.50 at expiration:


Initial cost:                                                            ($3,500)
Exercise 10, 55 calls and acquire 1,000 shares: ($55,000)
Sell 1,000 shares at market:                                $58,500
60 and 65 calls expire worthless:                         -0-
Net profit/loss:                                                    = 0

XYZ at 60 at expiration:


Initial cost:                                                            ($3,500)
Exercise 10, 55 calls and acquire 1,000 shares: ($55,000)
1,000 shares sold at the market:                          $60,000
60 and 65 calls expire worthless:                         -0-
Net profit:                                                          = $1,500

XYZ at 61.50 at expiration:


Initial cost:                                                            ($3,500)
Exercise 10, 55 calls and acquire 1,000 shares: ($55,000)
Called away on 2,000 shares at 60:                    $120,000
1,000 short shares bought back at market:         ($61,500)
65 calls expire worthless:                                     -0-
Net profit/loss:                                                      = 0

XYZ at 65.00 at expiration:

Initial cost:                                                             ($3,500)
Exercise 10, 55 calls and acquire 1,000 shares:  ($55,000)
Called away on 2,000 shares at 60:                     $120,000
1,000 short shares bought back at market:          ($65,000)
65 calls expire worthless:                                      -0-
Net loss:                                                             = ($3,500)

XYZ above 65.00 at expiration:
Initial cost:                                                             ($3,500)
Exercise 10, 55 calls and acquire 1,000 shares:  ($55,000)
Called away on 2,000 shares at 60:                     $120,000
Exercise 65 calls and acquire 1,000 shares:        ($65,000)
Net loss:                                                            =  ($3,500)

How to choose a strike price

A long butterfly spread can be created using either calls or puts, and the general characteristics are very similar regardless of your choice. While a long butterfly is a neutral strategy, you can put a very slight bullish or bearish bias on it, depending whether you use above the money (ABTM), around the money (RTM) or below the money (BTM) calls or puts.

Below is a table that may help you decide which strike prices to choose.

Considerations for selecting a strike price

Considerations for selecting a strike price

Source: Schwab Center for Financial Research.

The long butterfly strategy, which provides an opportunity to profit on a stock that is basically neutral, is one of the unique benefits of trading options, and something that simply can’t be done trading stocks alone.

I hope this article enhanced your understanding of options. 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

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