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Short Butterfly Spreads: Understanding the Basics

Short Butterfly Spreads: Understanding the Basics

Key Points
  • A short butterfly spread is a breakout strategy—appropriate when you expect a large movement in the underlying security either up or down over the life of the options.

  • This three-legged strategy involves three different strike prices established in a 1/2/1 ratio.

  • A short butterfly can be built with either calls or puts.

  • We look at how you might select strike prices for a short butterfly spread.

A short butterfly is a breakout strategy that has a limited profit zone if the underlying security rises sharply or falls sharply and a limited loss zone if the price of the underlying security ends up between the lowest and highest strike prices.

Short butterflies are typically used when you expect a large move in the underlying security (stock or ETF), but you don’t have a sense of the security’s direction. While they sound complicated (and might even look so pictured on a graph), short butterflies are fairly easy to understand, especially if you are familiar with long butterflies.

A short call (put) butterfly is a three-legged strategy with three different strike prices: 

  • Sell one call (put) at the lowest strike price,
  • Buy two calls (puts) with a middle strike price
  • Sell one call (put) with the highest strike price.

The options all have the same expiration date with a middle strike price halfway between the lower and the higher strikes. The position is considered "short" because a net cash credit is received when initiating it. Like many option strategies, the maximum gain, maximum loss, and breakeven points can all be calculated before you enter your order.

When to open a short butterfly trade

The ideal time to enter a short butterfly trade is when you expect a large movement in the underlying instrument (stock or ETF), but don’t have a sense of which way it might move. Typically, the strike prices are chosen when the underlying instrument is trading very near the middle strike price. Let’s take a look at a sample short butterfly trade.

Purpose:  Limited risk with limited profit potential

Short call butterfly spread:

Sell to open 10 XYZ Dec 60 Calls @ 4.70B    
Buy to open 20 XYZ Dec 65 Calls @ 1.80A
Sell to open 10 XYZ Dec 70 Calls @ .35B

Note that a short butterfly call (put) spread is always established in a 1/2/1 ratio. At Schwab, you'll 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 legs you are selling:

1 x + 4.70B  =   +4.70
2 x - 1.80A   =    -3.60
1 x + .35B    =    +.35
Net               =    +1.45 x 10 spreads = ($1,450) total up front credit

The market price of this butterfly spread is a net credit of 1.45, and the total credit would be 1.45 x the number of 1/2/1 spreads (10) x the option multiplier (100) = $1,450. 

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 short butterfly spread

Profit and loss profile for a short butterfly spread

Source: Schwab Center for Financial Research. 

The maximum profit on this strategy, which occurs above the highest strike price or below the lowest strike price, is $1,450. Two breakeven points sit at $61.45 and $68.55 while prices between $61.45 and $68.55 result in a loss. The maximum loss at expiration, which occurs only at the middle strike price of exactly $65, is -$3,550. 

A look at different expiration price scenarios

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

XYZ at $60 or below at expiration:
Initial credit:                                                               $1,450
All options expire worthless:                                         -0-
Net gain of 1.45 X 10 spreads:                                = $1,450

XYZ at $61.45 at expiration:
Initial credit:                                                               $1,450
Called away on 1,000 shares at 60:                         $60,000
Buy back 1,000 shares at market:                           ($61,450)
65 and 70 calls expire worthless:                                 -0-
Net profit/loss:                                                             = 0

XYZ at $65 at expiration:
Initial credit:                                                                $1,450
Called away on 1,000 shares at 60:                          $60,000
Buy back 1,000 shares at market:                            ($65,000)
65 and 70 calls expire worthless:                                  -0-
Net profit:                                                                 = ($3,550)

XYZ at $68.55 at expiration:
Initial credit:                                                               $1,450
Called away on 1,000 shares at 60:                         $60,000
Exercise 20, 65 calls and acquire 2,000 shares:    ($130,000)
Sell 1,000 shares at market:                                     $68,550
70 calls expire worthless:                                              -0-
Net profit/loss:                                                              = 0

XYZ at $70 at expiration:
Initial credit:                                                                $1,450
Called away on 1,000 shares at 60:                         $60,000
Exercise 20, 65 calls and acquire 2,000 shares:    ($130,000)
Sell 1,000 shares at market:                                     $70,000
70 calls expire worthless:                                              -0-
Net profit/loss:                                                         = $1,450

XYZ above $70 at expiration:
Initial credit:                                                               $1,450
Called away on 1,000 shares at 60:                         $60,000
Exercise 20, 65 calls and acquire 2,000 shares:    ($130,000)
Called away on 1,000 shares at 70:                         $70,000
Net profit/loss:                                                         = $1,450

How to choose a strike price

A short butterfly spread can be created using either calls or puts, and the general characteristics are very similar regardless of your choice. While a short butterfly is a breakout strategy, you can put a very slight bullish or bearish bias on it, depending upon 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. 

Because of the credit received from the sale of the upper and lower strike options, the short butterfly strategy, which provides an opportunity to profit on a stock that is expected to move sharply higher or sharply lower, typically comes at a much lower cost than a long straddle strategy. As a result, when the trade doesn’t work out, the risk is typically lower too.

I hope this article enhanced your understanding of short butterflies. 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
To discuss how this article might affect your investment decisions:
-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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Long Condor Spreads: Finding Good Candidates
Long Condor Spreads: Finding Good Candidates

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