What is Butterfly Spread?

A butterfly spread is another strategy used by traders. We purchase or sell three different call options in the butterfly spread. To build a butterfly spread, the trade purchases one European call with a low exercise price buys another European call with a high exercise price, and sells two European calls with an exercise price in between (usually near the current stock price). One critical aspect is that expiration dates are the same for all options. The trader expects stock prices to remain new to the exercise prices.

Examples of Butterfly Spread:

Let’s assume a trader who is building a butterfly spread. They purchased a long call with a strike price of USD 18 with a premium of USD 3, a long call with a strike price of 20, and a premium of USD 1. They also short two calls with a strike price of USD 18 and a premium of USD 2 each. If the price remains around the strike price, the trader will make a profit.

Furthermore, a butterfly spread can be either bullish or bearish, depending on whether the trader expects the underlying stock’s price to rise or fall. In a bullish butterfly spread, the trader buys an option with a lower strike price and sells two options with a higher strike price, while in a bearish butterfly spread, the trader buys an option with a higher strike price and sells two options with a lower strike price. The potential profit and loss for a this depend on the strike prices of the options and the premiums paid and received.

The maximum profit for a butterfly spread occurs when the underlying stock price is equal to the middle strike price at expiration, and the profit is equal to the difference between the two higher strike prices and the premium paid. However, if the underlying stock price rises or falls significantly, the trader may incur a loss. There is popular among options traders because they offer a limited-risk, limited-reward tradeoff. Traders can use butterfly spreads to generate income in a range-bound market or to hedge against significant price movements. However, as with any options trading strategy, traders must be aware of the risks involved and have a clear understanding of the potential profit and loss before entering into a butterfly spread.