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Butterfly Spread Strategy

A butterfly spread combines multiple options to create a position that profits when the underlying stays near a specific price at expiration.

A butterfly spread involves three strike prices: buy one in-the-money option, sell two at-the-money options, and buy one out-of-the-money option, all with the same expiration. The result is a position with a narrow profit range around the middle strike. Butterflies can be constructed with calls, puts, or a combination, and they are typically debit spreads (you pay to enter) where the maximum loss is limited to the net debit paid.

AAPL is at $190. You buy one $180 call for $11.00, sell two $190 calls for $5.00 each ($10.00 total), and buy one $200 call for $2.00. Net debit: $11.00 - $10.00 + $2.00 = $3.00 per share ($300 per contract). Maximum profit is $10.00 - $3.00 = $7.00 per share ($700), achieved if AAPL closes exactly at $190 at expiration. Maximum loss is the $3.00 debit paid. AAPL must stay between $183 and $197 to avoid a loss.

Types of Butterflies

Butterflies can be set up in various ways. A call butterfly uses all calls; a put butterfly uses all puts. An iron butterfly combines a bear call spread and a bull put spread at the same middle strike. A broken-wing butterfly has unequal wing widths, skewing the risk/reward to one side. Long butterflies are theta-positive (benefit from time decay) and vega-negative (hurt by rising volatility), while short butterflies have the opposite characteristics. The choice depends on your market outlook and volatility expectations.

Adjusting Butterflies

As the underlying moves away from the middle strike, the butterfly loses value asymmetrically. If AAPL rallies to $195, the position approaches the upper wing, and losses accelerate. Traders can adjust by: (1) closing the position early to salvage remaining value, (2) converting to a double diagonal by rolling the wings out in time, or (3) buying additional wings to widen the profit zone. Because of the narrow profit range, butterflies require precise timing and are typically held for days or weeks, not months.

FAQs

What is the ideal time to expiration for butterflies?

Most traders use 30-60 day options, entering when they expect the stock to converge toward the middle strike. Shorter time frames offer less premium cost but also less time for the convergence to occur.

How does implied volatility affect butterflies?

Butterflies have negative vega around the middle strike, meaning they lose value when implied volatility rises. Enter butterflies when IV is relatively high and expected to decline, giving you both time decay and volatility contraction benefits.

Can I trade butterflies on indices?

Yes. SPX and RUT butterflies are popular due to their cash settlement and favorable tax treatment (60/40 long-term/short-term capital gains under Section 1256). Index options also avoid early exercise risk that exists with equity options.

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