Definition of 'Butterfly Spread Option'

Definition: Butterfly Spread Option, also called butterfly option, is a neutral option strategy
that has limited risk. The option strategy involves a combination of various bull spreads and
bear spreads. A holder combines four option contracts having the same expiry date at three
strike price points, which can create a perfect range of prices and make some profit for the
holder. A trader buys two option contracts – one at a higher strike price and one at a lower
strike price and sells two option contracts at a strike price in between, wherein the difference
between the high and low strike prices is equal to the middle strike price. Both Calls and Puts
can be used for a butterfly spread. 

Any butterfly option strategy involves the following: 

1) Buying or selling of Call/Put options 

2) Same underlying asset 

3) Combining four option contracts 

4) Different strike prices, with two contracts at same strike price 

5) Same expiry date 

Description: The Butterfly Spread Option strategy works best in a non-directional market or

when a trader doesn’t expect the security prices to be very volatile in future. That allows the
trader to earn a certain amount of profit with limited risk. The best result of the strategy can
be seen when it’s near to expiry and at the money, i.e. the price of the underlying is equal to
the middle strike price. In this strategy, either you go for Calls or Puts or a combination of
both. In the same way, you either go long or short on options or a combination of longs and
shorts depending on what you are foreseeing in future and what is your payoff strategy. 

Example: Suppose, a trader is expecting some bullishness in Reliance

 Long Call Butterfly 
Federal Bank - Spot Price- 95
Lot Size   -  10,000
Long Call Butterfly Options Strategy

  Strike Price
(Rs)
Premium (Rs)         Ll (Premium * lot size
10000)
Total Premium Paid (Rs)
 Sell 2 ATM Call 95 4*2                  80,000 

Buy 1 ITM Call 93 3                  30,000 

Buy 1 OTM Call 97 6                  10,000 

 
Net Premium  (-8+3+6) 1 10,000 

Upper Breakeven (Rs)         Higher Strike price - Net Premium Paid

(97 - 1)       = 96
Lower Breakeven (Rs)         Lower Strike price + Net Premium Paid
(93 + 1)      = 94
Maximum Possible Loss (Rs)         Net Premium Paid        10000
Maximum Possible Profit (Rs)       Diff Between Adjacent Strike - Net Premium Debit
((95-93)-1) *10000 = 10000

Suppose, a trader is expecting some bullishness in Federal Bank, when it trades at Rs 95.
Now, a trader enters a long butterfly bull spread option by buying one lot each of March
expiry Call options at strike prices Rs 93 and Rs 97 at values of 3 (93 Call) and 6 (97 Call)
and then sell lots of Calls at strike price Rs 95 at 4. The cost to the trader at this point would
be 1 (6+3-(2(4)). If the strategy fails, this will be the maximum possible loss for the trader. If
the Federal Bank stock trades at the same level (i.e. Rs 95) on the expiry date in March end,
the Call option at the higher strike price will expire worthless as out-of-the-money (strike
price is more than the trading price), while the Call option at the lower strike price will be in-
the-money (strike price is less than trading price) and the two at-the-money Call options that
had been sold expired worthless.

There are various risks to this strategy, which include:

1) Higher implied volatility in case of long butterfly and lower implied volatility in case of
short butterfly 

2) Long expiry time as sentiments in the market can change 

3) Shorting option in this combination can work in reversal in case of some events related to
security 

4) Expiry of out-of-the-money options in case of all Calls or Puts or delivery on expiry date
can work in reverse for this strategy 

5) Higher trading costs, commissions and taxes 

Long Call/Put Butterfly: This means buying one Call/Put option at higher strike price and one
at lower strike price, and simultaneously selling two Calls/Puts at a strike price near to the
cash price of the same expiry and underlying asset (index, commodity, currency, interest
rate). This strategy involves limited risk, as the maximum amount the trader can lose is the
cost of Call/Put options and it will occur when the cash price trades beyond the range of high
and low strike prices at expiry. The maximum profitability will be when the cash price is
equal to the middle strike price on the expiry day. The breakeven points for this strategy are: 

Upper Breakeven Point = Higher strike price long Call/Put option (Strike Price - Premium
paid (Value of option)
Lower Breakeven Point = Lower strike price long Call/Put option (Strike Price + Premium
paid (Value of option)

Short Call/Put Butterfly: This means selling one Call/Put option at higher strike price and one
at lower strike price, and simultaneously buying two Calls/Puts at a strike price near to cash
price of the same underlying asset (index, commodity, currency, interest rates) and of same
expiry. The maximum a trader may lose is the strike price of long Call/Put options and that
will occur when the cash price is at the same level. The maximum profit will be when the
cash price is beyond the range of lower and higher strike prices on the expiry day. The
breakeven points of this strategy are: 
Upper Breakeven Point = Higher strike price long Call/Put option (Strike Price - Premium
paid (Value of option)
Lower Breakeven Point = Lower strike price long Call/Put option (Strike Price + Premium
paid (Value of option)