Butterfly Spread Option

A Butterfly Spread Option is a neutral options trading strategy that combines both bull and bear spreads using multiple call or put options with the same expiry date but different strike prices. It is designed to profit from low volatility in the underlying asset’s price, where the trader expects the asset to remain close to a specific target level at expiration.
The strategy involves creating a position that benefits when the underlying asset’s price stays near the middle strike price, offering limited profit potential and limited risk. It is widely used by professional traders seeking to capitalise on stable market conditions.

Structure and Components

A standard Butterfly Spread consists of four options contracts—either all calls or all puts—with three distinct strike prices. These are structured as follows:

• Lower Strike (K₁) – Buy one option
• Middle Strike (K₂) – Sell two options
• Higher Strike (K₃) – Buy one option

The strike prices are equally spaced:
K2−K1=K3−K2K₂ – K₁ = K₃ – K₂K2​−K1​=K3​−K2​
All options have the same expiration date and are based on the same underlying asset.
This combination results in a profit-loss graph shaped like a butterfly — with a peak (maximum profit) at the middle strike and two declining wings on either side (representing limited loss).

Types of Butterfly Spreads

1. Call Butterfly Spread: Constructed using call options. The trader buys one call at a lower strike, sells two calls at a middle strike, and buys one call at a higher strike.Suitable when expecting the price to stay near the middle strike.
2. Put Butterfly Spread: Constructed using put options. The trader buys one put at a higher strike, sells two puts at a middle strike, and buys one put at a lower strike.Produces similar payoff characteristics as the call butterfly.
3. Iron Butterfly Spread: Combines both call and put options — selling a call and a put at the same middle strike, while buying an out-of-the-money call and put to hedge risk.Often cheaper to set up and widely used for volatility trading.

Example: Call Butterfly Spread

Suppose a stock is trading at ₹100. A trader expects the price to remain around ₹100 until expiration. The trader could construct a call butterfly spread as follows:

Net Cost (Premium Paid) = (12 + 3) – 12 = ₹3
This ₹3 is the maximum loss (the cost of setting up the strategy).

Possible Outcomes at Expiry:

1. If stock price < ₹90: All options expire worthless → Loss = ₹3 (maximum loss)
2. If stock price = ₹100 (middle strike): Maximum profit is achieved.
   • Lower call (₹90) = intrinsic value ₹10
   • Two middle calls (₹100) = both expire worthless
   • Higher call (₹110) = worthlessProfit = ₹10 – ₹3 = ₹7 (maximum profit)
3. If stock price > ₹110: Both long and short calls offset each other → Loss = ₹3 (maximum loss)

Thus, profit is maximised when the stock closes at ₹100 and declines symmetrically as the price moves away.

Profit and Loss Characteristics

• Maximum Profit: Occurs when the underlying asset’s price equals the middle strike price at expiry.

  Max Profit=K2−K1−Net Premium Paid\text{Max Profit} = K₂ – K₁ – \text{Net Premium Paid}Max Profit=K2​−K1​−Net Premium Paid

• Maximum Loss: Limited to the net premium paid (cost of entering the position).

  Max Loss=Net Premium Paid\text{Max Loss} = \text{Net Premium Paid}Max Loss=Net Premium Paid

• Breakeven Points: There are two breakeven levels:

  Lower Breakeven=K1+Net Premium Paid\text{Lower Breakeven} = K₁ + \text{Net Premium Paid}Lower Breakeven=K1​+Net Premium Paid Upper Breakeven=K3−Net Premium Paid\text{Upper Breakeven} = K₃ – \text{Net Premium Paid}Upper Breakeven=K3​−Net Premium Paid

Payoff Profile

The payoff diagram of a butterfly spread has the shape of a “tent” or “wings.” It shows:

• Profit concentrated near the middle strike.
• Losses tapering off equally on both sides beyond the breakeven points.
• Limited downside and upside risk.

This structure makes the butterfly spread ideal for markets expected to experience low price volatility.

Advantages of Butterfly Spread

• Limited Risk: The maximum loss is predetermined and equals the net premium paid.
• Defined Reward: The maximum profit is fixed and occurs at the middle strike.
• Low Cost: Compared to other multi-leg strategies, it requires smaller capital outlay.
• Volatility Strategy: Profits from low volatility, making it effective in range-bound markets.
• Flexibility: Can be constructed using either calls or puts, or a combination (iron butterfly).

Disadvantages

• Limited Profit Potential: The reward is capped and occurs only if the asset closes near the middle strike.
• Time Decay Impact: Profits diminish as time value erodes; timing is crucial.
• Complexity: Involves multiple legs, which may increase transaction costs.
• Unfavourable in Volatile Markets: Sharp price movements lead to losses as both outer options may expire worthless.

Comparison: Butterfly vs. Iron Butterfly

While both aim to profit from low volatility, the iron butterfly may be preferred for traders seeking to earn premium income rather than paying it upfront.

Practical Applications

Butterfly spreads are used by traders and portfolio managers for:

• Volatility Forecasting: Benefiting from expected stability in prices.
• Income Generation: Through controlled option structures with capped risks.
• Hedging: Reducing exposure to price fluctuations around a target level.
• Arbitrage Opportunities: Exploiting mispricing among different strike options.

Example: Put Butterfly Spread

Assume a stock trades at ₹200, and an investor believes it will stay close to that level by expiry.

• Buy 1 Put at ₹190
• Sell 2 Puts at ₹200
• Buy 1 Put at ₹210

If the stock remains near ₹200 at expiry, the sold puts expire worthless while the bought puts may offer intrinsic value, generating profit.

Suitability and Risk Profile

The Butterfly Spread is suitable for:

• Traders expecting minimal movement in the underlying price.
• Conservative investors seeking defined risk and limited profit.
• Situations where implied volatility is expected to decline.