At some point, you will likely come across the term butterfly spread. It’s a strategy popular among many traders, but why? A short butterfly, or a long butterfly position, can be extremely useful in creating scenarios with a capped risk/reward. Then, depending on the position structure, you can maximize returns from any market conditions. Combining call and put options at different strike prices can potentially take advantage of volatile and stagnant markets.
What is a Butterfly Spread?
Firstly, the term butterfly spread relates to the spine and the wings of a butterfly when fully open. In investment terms, the spine is the current asset price. Meanwhile, the size of each wing is the area of fixed risk and reward. Therefore, a butterfly spread will use three different strike prices: The lower price, current price, and a higher price.
When writing an option contract, you will receive a commission to allow someone to buy (call) or sell (put) an asset at a fixed price over a fixed period. When acquiring an option, you will pay for the opportunity to buy (call) or sell (put) an asset at a fixed price over a fixed period. For example, a butterfly spread strategy involves four options. These could be four call options, four put options, or a mixture of the two.
How does it work?
Using call and put options, you can create an array of different investment positions. Investment indices such as the E-Mini S&P 500 Futures are incredibly liquid and often volatile. However, offer the perfect opportunity to create several butterfly spreads. The more liquid the underlying market:
- The lower the chance of the market mispricing assets
- The greater the opportunity to deal in large contract sizes
- The fewer restrictions, even in fast-moving markets
All types of butterfly spreads take into account the intrinsic value and the time value of an option. For example:
- Asset price: $60
- Call option strike price: $50
- Three-month call option price: $15
Upon purchase, the call option price consists of:
- The intrinsic value of $10 (the difference between the call price and the asset price)
- Time value $5 (relating to the three month option period)
So, let’s assume the price is $60 on expiry in this scenario. The call option would be worth $10 as the time value will have eroded. Thus, by cleverly taking advantage of a mix of call and put options, intrinsic and time value, it is possible to lock in some potentially significant profits.
Butterfly Spread Types
Next, we’ll take a look at the different types of butterfly spreads. Then, finally, we’ll examine their structure and under what market conditions you can best maximize profit and minimize risk.
Long Call Butterfly Spread
Before we look at this option in more detail, it is crucial to realize what this type of spread entails. A long call butterfly spread, looking to take advantage of low volatility, consists of:
- The purchase of one in-the-money call option (strike price less than asset price)
- The writing (sale) of two at-the-money call options (strike price equal to asset price)
- The purchase of one out-of-the-money call option (strike price more than asset price)
You are taking advantage of the time value of the at-the-money call options, selling to receive income. The purchase of the out-of-the-money call options would be an insurance policy if the asset price increased significantly over the period. The purchase of the in-the-money call option provides cover for the written options. This position will create a net debit.
Short Call Butterfly Spread
As we will demonstrate in a moment, a short call butterfly spread means increasing your returns on significant movement, either upwards or downwards. The position itself consists of:
- Writing one in-the-money call option at a lower strike price
- Purchasing two at-the-money call options
- Writing an out-of-the-money call option at a higher strike price
The key to this short butterfly strategy is purchasing the two at-the-money call options and the receipt of income from the written options, creating a net credit. If the asset price fell below the lower strike price, all options would be worthless on expiry, and you would take the net credit as your profit. Conversely, if the asset price were to rise above the higher strike price, the value of the two at-the-money call options would cover the two written options and more. This position would create a net credit when first set up.
Long Put Butterfly Spread
The long put butterfly spread strategy is a means of benefiting from a relatively stagnant market. The make-up of the four options contracts is as follows:
- Purchase of a put option with a strike price below the asset price
- Writing two at-the-money put options
- Purchase a put option with the strike price above the asset price (in-the-money)
In this scenario, the best outcome would be if the asset price was to expire at the same price as the at-the-money puts. This situation would enable the investor to take advantage of the time value with the at-the-money puts while maximizing the in-the-money value. The out-of-the-money put option is simply an insurance policy in case the asset price was to collapse. Thus, the initial strategy creates a net debit.
Short Put Butterfly Spread
The short put butterfly spread strategy is a means of benefiting from significant volatility in the market. The system itself is made up of:
- Writing one out-of-the-money put option
- Purchasing two at-the-money puts
- Writing an in-the-money put option
In this scenario, you would maximize your profits if the asset value was above the highest option price or below the lowest option price on expiry. The worst-case scenario would be if, over the period, the price did not move. As a consequence, the at-the-money put options would be worthless. The lower written put option would also be useless, and therefore there will be no need to repurchase it to close the position.
So the maximum downside with a short butterfly strategy would be the difference between the higher and the middle strike prices, less the written option income. So there is a net credit when setting up a short put butterfly spread.
How to Use the Butterfly Spread in Trading
When looking at a butterfly spreads, there are two main issues to take into consideration regarding the expected movement of a stock or index:
Minimal Volatility
Suppose you believe that a stock or index will experience minimum volatility over a specific period. In that case, you can use long call butterfly spreads and long put butterfly spreads to create a position. There will be a net cost to set up this strategy, but that will be your maximum loss. You can calculate the maximum potential profit when opening the position.
Expected Volatility
If you expect volatility on the upside or the downside with a particular stock or index, it may be sensible to look at a short call butterfly spread or a short put butterfly spread. As you are buying at-the-money calls/puts, there is no intrinsic value, just time value; thereby, movement in the “right” direction will maximize your profits.
Simplifying Butterfly Spreads
The key to the profit or loss on any butterfly spread revolves around both the intrinsic value of an option and the time value. The inherent value is the basic price differential between the strike price and the actual stock/index price. For example, if you had an option to buy the S&P 500 at 4200 and the option expired with the index at 4300, the intrinsic value would be 100. As the option had expired, there would be no time value. However, if, for example, you bought a three-month option, on purchase, the price would include any intrinsic value and an element of time value (which would slowly erode as you near expiry).
You tend to find that at-the-money options are more popular and generally have a greater degree of time value included in the option price. This is simply a case of supply and demand: the more demand, the greater the option price. Thus, time value is often described as the premium.
Options or Futures?
When looking to trade the S&P 500 index, the most popular method is the S&P 500 E-Mini futures market. However, it is also possible to trade the S&P 500 index via S&P 500 E-Mini traded options. Futures and options markets both trade on three-month contracts, although there is one main difference. With the S&P 500 E-Mini futures market, you can only buy or sell the index futures price at that time. However, those looking to undertake butterfly spreads on the S&P 500 can use the S&P 500 E-Mini traded options market.
The S&P 500 E-Mini traded options market offers a range of strike prices out-of-the-money, at-the-money, and in-the-money. Consequently, and due to the huge liquidity this market attracts, you can create your own butterfly spreads based on the S&P 500 index.
S&P 500 E-Mini futures prices are constantly changing in tandem with the S&P 500 index. Unfortunately, it is impossible to create the type of butterfly spreads we have discussed in this article using the futures market. However, many people create a different type of spread that allows you to buy/sell a short-term futures contract to let you counteract this by buying/selling a longer-term futures contract.
This type of spread involves contracts with different expiry months. Therefore, it is more often referred to as a calendar spread.
In conclusion, the only way to undertake a butterfly spread is by using the S&P 500 E-Mini traded options market. This allows you to pick and choose in-the-money, at-the-money, and out-of-the-money options, taking control of your maximum gains/losses.
Examples of Using the Butterfly Spread
We will now look at some examples of butterfly spreads based on ABC Company which is currently valued at $100. In this instance, we will use a lower strike price of $95, an at-the-money strike price of $100, and a higher strike price of $105.
Long Call Butterfly Spread
This is the trading summary when setting up a long call butterfly spread. You buy an in-the-money call and an out-of-the-money call while selling two at-the-money calls.
| Buy/Sell | Contracts | Series | Price | Cost |
| Buy | 1 | ABC 95 Call | $6.40 | ($6.40) |
| Sell | 2 | ABC 100 Call | $3.30 | $6.60 |
| Buy | 1 | ABC 105 Call | $1.45 | ($1.45) |
| Net cost | ($1.25) |
We will now take a look at the impact of the position on expiry. Let’s take in several different prices. As you can see, the worst-case scenario is a loss of $1.25. The best-case scenario is a profit of $3.75.
| Price at expiry | 95 Call option Profit/Loss | 100 Call option Profit/Loss | 105 Call option Profit/Loss | Net profit/loss |
| 110 | $8.60 | ($13.40) | $3.55 | ($1.25) |
| 105 | $3.60 | ($3.40) | ($1.45) | ($1.25) |
| 100 | ($1.40) | $6.60 | ($1.45) | $3.75 |
| 95 | ($6.40) | $6.60 | ($1.45) | ($1.25) |
| 90 | ($6.40) | $6.60 | ($1.45) | ($1.25) |
Short Call Butterfly Spread
This is when a short call butterfly spread, selling an in-the-money call an out-of-the-money call while buying two at-the-money calls.
| Buy/Sell | Contracts | Series | Price | Cost |
| Sell | 1 | ABC 95 Call | $6.40 | $6.40 |
| Buy | 2 | ABC 100 Call | $3.30 | ($6.60) |
| Sell | 1 | ABC 105 Call | $1.45 | $1.45 |
| Net Income | $1.25 |
This is the range of outcomes taking into account an expiry price between $90 and $110. The maximum gain is $1.25, while the maximum loss is $3.75.
| Price at expiry | 95 Call option Profit/Loss | 100 Call option Profit/Loss | 105 Call option Profit/Loss | Net profit/loss |
| 110 | ($8.60) | $13.40 | ($3.55) | $1.25 |
| 105 | ($3.60) | $3.40 | $1.45 | $1.25 |
| 100 | $1.40 | ($6.60) | $1.45 | ($3.75) |
| 95 | $6.40 | ($6.60) | $1.45 | $1.25 |
| 90 | $6.40 | ($6.60) | $1.45 | $1.25 |
Long Put Butterfly Spread
When setting up a long put butterfly spread, you will buy an in-the-money and an out-of-the-money put while selling two at-the-money put contracts.
| Buy/Sell | Contracts | Series | Price | Cost |
| Buy | 1 | ABC 95 Put | $1.45 | ($1.45) |
| Sell | 2 | ABC 100 Put | $3.30 | $6.60 |
| Buy | 1 | ABC 105 Put | $6.40 | ($6.40) |
| Net cost | $1.25 |
The range of outcomes for a long put butterfly spread, taking into account a price of between $90 and $110 on expiry, is as follows.
| Price at expiry | 95 Put option Profit/Loss | 100 Put option Profit/Loss | 105 Put option Profit/Loss | Net profit/loss |
| 110 | ($1.45) | $6.60 | ($6.40) | ($1.25) |
| 105 | ($1.45) | $6.60 | ($6.40) | ($1.25) |
| 100 | ($1.45) | $6.60 | ($1.40) | $3.75 |
| 95 | ($1.45) | ($3.40) | $3.60 | ($1.25) |
| 90 | $3.55 | ($13.40) | $8.60 | ($1.25) |
Short Put Butterfly Spread
A short put butterfly spread will see you sell an in-the-money put and an out-of-the-money put while buying two at-the-money puts.
| Buy/Sell | Contracts | Series | Price | Cost |
| Sell | 1 | ABC 95 Put | $1.45 | $1.45 |
| Buy | 2 | ABC 100 Put | $3.30 | ($6.60) |
| Sell | 1 | ABC 105 Put | $6.40 | $6.40 |
| Net Income | $1.25 |
With a range of expiry prices between $90 and $110, you can see that the maximum profit is $1.25 while the maximum loss is $3.75.
| Price at expiry | 95 Put option Profit/Loss | 100 Put option Profit/Loss | 105 Put option Profit/Loss | Net profit/loss |
| 110 | $1.45 | ($6.60) | $6.40 | $1.25 |
| 105 | $1.45 | ($6.60) | $6.40 | $1.25 |
| 100 | $1.45 | ($6.60) | $1.40 | ($3.75) |
| 95 | $1.45 | $3.40 | ($3.60) | $1.25 |
| 90 | ($3.55) | $13.40 | ($8.60) | $1.25 |
Obviously, these figures are relatively small. However, they give you an idea of the potential capped losses and gains you can create using butterfly spread strategies. Of course, ramping up the number of contracts will impact the potential profit and potential loss. But, conversely, they will always be capped.
Butterfly Spread Risk/Reward
The key to a butterfly spread is that both losses and gains are capped when you open the position. You need to open all four contracts simultaneously and close the contracts at the same time to maintain this control.
Long call and long put butterfly strategies take advantage of a lack of movement and the receipt of time value on at-the-money options. These types of butterfly spread options are useful for markets that are trading sideways or stocks that have perhaps recently had their results, with little or no further news expected in the short term. As a result, you can often see investors, especially traders, exiting stocks just before or just after the results.
The Short call and short put butterfly strategies try to bank on a degree of volatility on the upside or the downside. The purchase of at-the-money options is relatively cheap. At the same time, writing an in-the-money option creates a degree of income. Short butterfly strategies are useful when a market or a particular stock has risen to unsustainable highs without additional news flow. If further news flow comes, the price may move higher. Meanwhile, a lack of additional news could see profit-taking. Either way, there is a good chance of volatility in the short to medium term.
The potential return will depend upon the underlying option prices, which will take into account the intrinsic value and time value. As at-the-money option series tend to be more active, the time value is often greater than those for out-of-the-money options. However, as you will see from the examples above, it is fairly easy to work out the risk/reward for any butterfly spread strategy.
Final Thoughts
When you strip down the basics of any butterfly spread strategy, short butterfly or long butterfly, the key is utilizing the time and intrinsic value in option prices. The fact that you are also taking positions as insurance can capping both the upside and downside. In this case, looking to protect your portfolio while maximizing any short and medium-term market fluctuations can be a useful means of creating additional income.
