Definition
A butterfly spread is an options trading strategy that aims for limited risk and capped profits. It involves multiple positions (typically four options) with three different strike prices, where the options are arranged such that the outer two strike prices are equidistant from the middle strike price, which is often the at-the-money (ATM) strike. This strategy is generally executed with either all calls or all puts (or a mix), and the most successful outcome occurs when the underlying asset remains close to the middle strike price at expiration.
| Butterfly Spread vs Straddle Spread |
|---|
| Feature |
| Risk |
| Profit Potential |
| Type |
| Notes |
Examples
- Long Call Butterfly Spread: You buy 1 call at a lower strike (e.g., $50), sell 2 calls at a middle strike (e.g., $55), and buy 1 call at a higher strike (e.g., $60). The middle strike is where you want the asset at expiration.
- Long Put Butterfly Spread: You buy 1 put at a higher strike (e.g., $60), sell 2 puts at a middle strike (e.g., $55), and buy 1 put at a lower strike (e.g., $50). This works in the opposite direction of the call butterfly.
Related Terms
- Bull Spread: A strategy involving the purchase of a lower strike option alongside the sale of a higher strike option, allowing for limited risk and profit potential.
- Bear Spread: Similar to a bull spread, but designed for falling markets involving selling a lower strike option while buying a higher strike option.
graph TD;
A[Buy Low Strike Option] --> B[Sell Middle Strike Option];
A --> C[Buy High Strike Option];
B --> D[Profit is Maximized Near Middle Strike];
Fun Insights and Facts
- Did you know? The term “butterfly” in trading comes from the shape of the profit and loss graph for this strategy, which can resemble a butterfly flapping its wings? 🦋
- According to options trading experts, butterfly spreads are like a financial hammock; they keep you stable as long as the market doesn’t swing too much!
Humorous Citations
- “Trading butterfly spreads is like hosting a potluck and only praying the main dish doesn’t burn - all hope is in the center!” - Anonymous Trader.
- “If you want to feel like a financial wizard without risking your wand (or your money), try the butterfly spread!” - Investment Humorist.
Frequently Asked Questions
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Q: What happens if the stock price is above the upper strike at expiration?
- A: You might feel like you’re holding an empty piñata. The payoff is not favorable, and your profit is capped.
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Q: Why would a trader use a butterfly spread?
- A: To profit in a stretched-out market where unpredictability is low, but the desire for cupcake-like gains is high! 🧁
Suggested Further Reading
- Options as a Strategic Investment by Lawrence G. McMillan
- The Complete Guide to Option Pricing Formulas by H. Scott Foged
Online Resources
Test Your Knowledge: Butterfly Spread Challenge! 🦋
## What is the main goal of a butterfly spread?
- [x] To earn maximum profit when the underlying asset stays stable
- [ ] To hedge against a falling market
- [ ] To experience unlimited gains
- [ ] To lose money significantly
> **Explanation:** The primary aim of a butterfly spread is to derive profit when the underlying asset doesn't fluctuate too much around the middle strike price.
## How many options are typically involved in a butterfly spread?
- [x] Four
- [ ] Two
- [ ] Three
- [ ] Five
> **Explanation:** A butterfly spread typically consists of four options involving either all calls, all puts, or a combination centered around three different strike prices.
## The ideal scenario for a butterfly spread is when the underlying asset's price is:
- [ ] Far from all strike prices
- [ ] Once in a blue moon when it jumps too high
- [ ] Close to the middle strike price at expiration
- [x] Close to the lower and higher strike prices
> **Explanation:** The best outcome occurs when the underlying asset stays close to the middle strike price at expiration, resulting in maximum profit from your perfectly arranged options.
## In a butterfly spread, if the market moves significantly, the strategy:
- [ ] Results in fabulous profits
- [x] May incur small losses or gains, depending on the moves
- [ ] Guarantees a good night’s sleep
- [ ] Is a total disaster
> **Explanation:** A butterfly spread is designed for neutral markets. If the market moves significantly, it can lead to small losses instead of blowout profits!
## What shape does a butterfly spread’s profit and loss graph resemble?
- [ ] A rainbow
- [ ] A rollercoaster
- [x] A butterfly
- [ ] A squashed pancake
> **Explanation:** The profit and loss graph of a butterfly spread visually resembles a butterfly, flapping its "winged" profits!
## Which of the following is NOT a feature of a butterfly spread?
- [ ] Capped profits
- [ ] Fixed risk
- [x] Unlimited profit potential
- [ ] Market neutrality
> **Explanation:** The butterfly spread offers capped profit potential and fixed risk, making it not suitable for those looking for cooks who want to stir the pot!
## Butterfly spreads can be executed with which of the following options?
- [ ] Only puts
- [ ] Only swaps
- [x] Both calls and puts
- [ ] Only stocks
> **Explanation:** You can use both calls and puts to construct a butterfly spread, giving versatility a warm butterfly hug!
## Is there a maximum loss in a butterfly spread?
- [ ] Yes, it can be high
- [x] Yes, it's predetermined
- [ ] No, there is no max
- [ ] Only if you lose the plot
> **Explanation:** Yes! With a butterfly spread, the maximum loss is predefined at the onset of the trade, allowing you peace of mind like a well-read book!
## Why might an investor choose a butterfly spread strategy?
- [ ] To enjoy risk-taking
- [x] For a market-neutral approach with limited risk
- [ ] To instantly make a fortune
- [ ] To confuse their analysts
> **Explanation:** Investors may choose butterfly spreads mainly for their market-neutral aspect, limiting the risk while banking on the stability of the asset in question!
## All of the following are parts of a butterfly spread EXCEPT:
- [x] A hairy exchange
- [ ] The outer strikes
- [ ] The middle strike
- [ ] The net credit or debit
> **Explanation:** “A hairy exchange” doesn’t exist in butterfly spreads! It’s all about valid strikes and net variations, folks.
Thank you for fluttering through this exploration of butterfly spreads! Remember, the markets may be full of surprises, but with the right strategies, even a butterfly can spread its wings among the thorns! 🌼
