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Understanding the Long Butterfly Spread Strategy in Options Trading

7 August 2021 By GO Markets

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Options trading offers a multitude of strategies that cater to various market conditions and risk appetites. One such strategy that traders often employ is the “Long Butterfly Spread.” In this article, we will delve into the intricacies of the Long Butterfly Spread, exploring its components, mechanics, and potential advantages.

At its core, the Long Butterfly Spread is a neutral options strategy that traders utilize when they expect minimal price movement in the underlying asset. It involves using a combination of long and short call or put options with the same expiration date but different strike prices. This strategy is particularly useful when you anticipate that the underlying asset will remain relatively stable within a specific range.

To construct a Long Butterfly Spread, you’ll need to execute three transactions with options contracts. Let’s break down the components:

Buy Two Options: The first step involves buying two options contracts. These contracts should be of the same type, either both calls or both puts, and share the same expiration date. One of these options should be an “in-the-money” option, while the other should be an “out-of-the-money” option.

Sell One Option: The next step is to sell one options contract, which should be positioned between the two contracts purchased in the previous step. This sold option should have a strike price equidistant from the two bought options and, like them, should also have the same expiration date.

Now, let’s understand the mechanics of the Long Butterfly Spread and how it can generate profits:

Profit Potential:
The Long Butterfly Spread is designed to profit from minimal price movement in the underlying asset. It thrives in a scenario where the underlying asset closes at the strike price of the options involved in the strategy at expiration. In such a case, the trader reaps the maximum profit, which is the difference between the two middle strike prices minus the initial cost of the strategy.

Limited Risk:
One of the key advantages of the Long Butterfly Spread is its limited risk profile. The maximum potential loss is capped at the initial cost of establishing the strategy, making it a prudent choice for risk-averse traders. This risk limitation is due to the fact that the trader is simultaneously long and short options, which mitigates the potential for substantial losses.

Breakeven Points:
In a Long Butterfly Spread, there are two breakeven points. The first breakeven point is below the lower strike price of the strategy, and the second breakeven point is above the higher strike price. As long as the underlying asset closes within this range at expiration, the trader will either realize a profit or minimize their loss.

Implied Volatility Impact:
Implied volatility plays a crucial role in the Long Butterfly Spread. When implied volatility is low, it reduces the cost of the strategy, making it more attractive. Conversely, when implied volatility is high, the strategy’s cost increases, potentially affecting the risk-reward ratio. Therefore, traders should carefully assess implied volatility before implementing this strategy.

Time Decay:
Time decay, also known as theta decay, can work in favor of the Long Butterfly Spread. As time passes, the value of the options involved in the strategy erodes. This erosion can benefit the trader if the underlying asset remains within the desired range. However, if the asset moves significantly, it may offset the time decay benefits.

Scenario Analysis:
Let’s consider a practical example to illustrate the Long Butterfly Call Spread. Suppose you are trading Company XYZ’s stock, which is currently trading at $100 per share. You anticipate that the stock will remain stable in the near future and decide to implement a Long Butterfly Call Spread.

Buy 1 XYZ $95 Call option for $6 (in-the-money).
Sell 2 XYZ $100 Call options for $3 each (at-the-money).
Buy 1 XYZ $105 Call option for $1 (out-of-the-money).
The total cost of this strategy is $1 (6 – 3 – 3 + 1).

Now, let’s examine the potential outcomes:

If Company XYZ’s stock closes at $100 at expiration, you will achieve the maximum profit of $4. The $105 call option will expire worthless so you will lose the $1 you paid, the $95 call option will make a net loss of $1 ($6 cost -$5 profit) and two $100 call options will be worth $3 each.
If the stock closes below $95 or above $105, the strategy will result in a maximum loss of $1, which is the initial cost.

Any closing price between $95 and $105 will yield a profit or loss within this range, depending on the precise closing price.

In conclusion, the Long Butterfly Spread is a versatile options trading strategy that offers limited risk and profit potential in stable market conditions. It is a strategy that requires careful consideration of strike prices, implied volatility, and time decay. Traders should always conduct thorough analysis and risk management before implementing any options strategy, including the Long Butterfly Spread. When used judiciously, this strategy can be a valuable addition to a trader’s toolkit for capitalizing on low-volatility scenarios.

Disclaimer: Articles are from GO Markets analysts and contributors and are based on their independent analysis or personal experiences. Views, opinions or trading styles expressed are their own, and should not be taken as either representative of or shared by GO Markets. Advice, if any, is of a ‘general’ nature and not based on your personal objectives, financial situation or needs. Consider how appropriate the advice, if any, is to your objectives, financial situation and needs, before acting on the advice. If the advice relates to acquiring a particular financial product, you should obtain and consider the Product Disclosure Statement (PDS) and Financial Services Guide (FSG) for that product before making any decisions.