Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-07-20T15:38:20+05:30
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Introduction

"Butterfly spread" denotes to an options strategy which includes bull and bear spreads with a defined risk and capped profit. The most lucrative scenario for these spreads, which are meant to be market-neutral strategies, is for the underlying asset to remain stationary until option expiration. They either involve four puts, four calls, or a mix of both with three strike prices.

Let us have a deeper understanding of one of the most talked about Options strategies – the Butterfly option strategy.
 

What Is Butterfly Options Strategy?

The Butterfly strategy often termed “fly,” is a risk, Options strategy that is non directional and is designed to encourage the investor for good profitability. This occurs when the future volatility of the underlying asset could be higher or lower than that asset’s present implicated volatility. 

To simplify, it is a strategy that assimilates the bear and bull spreads of an asset with a limited or certain risk and a capped profit. This makes it an efficient strategy with a maximum payoff if the asset fails to make movements before options expiration.

You will learn more about the Butterfly strategy as you read.
 

How Does Butterfly Options Strategy Work?

In such a case, the investor combines four options contracts having the same expiry date at three strike price points to create a stable range of prices that can help make profits. 

A trader then buys two option contracts – one at a higher strike price and another at a lower strike price and then sells two option contracts at a strike price in between the above range such that the middle strike price is equal to the difference between the high and low strike prices of the same underlying asset. The Calls and Puts can be used for a butterfly spread within the same expiry date.

It works best in a non-directional market, i.e., when a trader doesn’t expect the security prices to be very volatile in the future. This allows the trader to earn a certain expected profit by taking a restricted risk. The best outcome of the butterfly option strategy is derived when it is near its expiry and the underlying asset's price is equal to the middle strike price. 

You might also want to learn about the short butterfly option strategy which we have detailed below. 
 

Types Of Butterfly Spreads Or Butterfly Options Strategy

Now that we know the basic picture of the Butterfly strategy let us understand the possible tweaks and modalities that, when worked upon, can change the strategy a bit as per the situation and desired outcome. 

As discussed earlier, high and low strike prices options are supposed to be at a similar distance from the middle strike prices. 

For this, a butterfly option strategy example may help. 

A Butterfly strategy example will be if the middle strike price is Rs. 4,965 for an underlying asset, the lower and upper options should have strike prices equally distant from Rs. 4,965, i.e., at Rs. 4,551 and Rs. 5,378, as both are Rs. 413 away from the mid-strike price. 

The various types we shall discuss now are simply different combinations of these options. This helps form diverse forms of butterfly spreads that are curated to be profitable under different volatility conditions. The types are discussed with greater detail as follows:

1. Long Call Butterfly Spread

Buying one in-the-money call option contract with a reduced strike price, writing two at-the-money or medium strike price call options, alongside then purchasing one out-of-the-money call option with an increased strike rate results in the long call butterfly or long butterfly option strategy. 

A Net Debt is formed when you enter the deal. The underlying price at expiration should match the written calls to realize the greatest profit. Quantitatively, the maximum profit is equal to the written option's strike price after deducting any premiums and fees that must be paid. The total cost of premiums and commissions is the most amount of loss that can occur. It is also one of the best butterfly option strategy. 

2. Short Call Butterfly Spread

The short butterfly options strategy involves buying two at-the-money call options, selling two out-of-the-money call options, and then selling one in-the-money call option with a lower strike price. 

In this instance, a Net Credit is produced when the deal is made. The approach maximizes profit when the underlying price is under the reduced strike at expiration or above the upper strike price.
The most gain is equivalent to the starting premium with fewer commissions, but the most amount of loss is equivalent to the strike price of the purchased call, less the premiums and decreased strike price earned.

3. Long Put Butterfly Spread

This type of spread is produced by purchasing a put with a decreased strike price, selling two at-the-money puts, and then purchasing a put with a higher strike price. 

Taking the position results in net debt creation. Pretty similar to the long call Butterfly strategy, this position's maximum gain occurs during the remainder of the underlying at the intermediate options' strike price. The more the strike price, the lesser the sold strike put less the paid premium, which determines the maximum profit. The trade's maximum loss is capped at the upfront fees and commissions.

4. Short Put Butterfly Spread

Drafting one out-of-the-money put option with a decreased strike rate, purchasing two puts that are in the money, and then writing an in-the-money put option with an increased strike price results in the short put Butterfly strategy. 

If the underlying price falls under the reduced strike price or above the upper strike at expiration, this strategy makes its maximum profit. The premiums collected represent the strategy's maximum profit. The higher the strike price, the lesser the strike of the acquired put and less the premiums received, which equals the maximum loss. In this process, you will also want to learn about option butterfly. 

5. Iron Butterfly Spread

This type of spread is made by purchasing a put option that is out-of-the-money with a reduced strike price, creating a put option that is in the money, writing a call option that is in the money, and purchasing a call option that is out-of-the-money with an increased strike price. 

Consequentially, it is a deal most useful for low volatility conditions and has a net credit. The maximum profit is when the underlying remains at the mid strike price. The premiums collected represent the greatest profit. The maximum loss is equal to the difference between the strike prices of the written calls and bought ones, less the premiums earned.

6. Reverse Iron Butterfly Spread

Creating an out-of-the-money put at a reduced strike rate, purchasing an at-the-money put, writing an out-of-the-money call and purchasing an at-the-money call, at an increased strike rate together form this type of spread. This results in a net negative trade that works best in high-volatility circumstances. 

The maximum profit is recognized when the underlying price changes below or above the higher or reduced strike prices. The risk of the strategy is constrained to the premium required to obtain the position. The difference between the written call's strike price and the bought call's strike price, less the paid premiums, is the maximum profit. That is why the butterfly strategy success rate is good. 
 

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Frequently Asked Questions

Now that we have a fair idea of the different ways the combinations of the contract options can be, we have identified six major types of the Butterfly strategy. 

For the categories of long and short call and long put and short put butterfly option strategies, we have noticed that each is a three-part strategy. On the contrary, the iron and reverse iron butterfly strategies are based on a four-part process of handling the four option prices with careful analysis and judgment.

Now that we have already understood what a Butterfly strategy is, let's see how different it is from a straddle option strategy. The latter involves two transactions in options on the same underlying, only this time with opposite positions. One has a great danger, the other a low risk. 

The purchase or sale of certain option derivatives that enable the holder to benefit heavily relies upon the underlying security changes prices regardless of the direction of price movement, which is thus required.
 

Well, your risk is reduced but not entirely by the strategy. A loss could result if the asset price expires at the intermediate strike price. The middle strike rate is less than the lowest strike price, and the premiums are paid to represent the greatest loss.

The underlying stock would make the most money if it were outside the wings when the option expired. Every option would expire worthless if the price fell below the lower strike; every option would be exercised and result in a loss if the stock rose over the upper strike.

When the stock price is anticipated to move outside the range between the highest and lowest strike prices, a short Butterfly strategy using calls is the best course of action. However, a short butterfly spread has a smaller profit margin than a long straddle or long strangle.

Loss is recognised if the stock price fluctuates excessively in either direction. Long call butterfly spreads fail to display sufficient profit if volatility is continuous until the stock price nears the center strike price and the spread is very close to expiration.

The higher the strike price, the less the sold strike put less the premium paid, which determines the maximum profit. The trade's maximum loss is capped at the upfront fees and commissions.

When the forecast calls for stock price movement close to the spread's center strike price, a long butterfly spread with calls is the best course of action because long butterfly spreads benefit from time decay. The potential risk of a long Butterfly strategy is constrained, in contrast to that of a short strangle or straddle.

The risk is restricted to the position's cost, which includes commissions, and the potential reward is "substantial" in percentage terms. For this method of purchasing butterfly strategies to be successful, the stock price must remain within the range of the butterfly's lower and upper strike price.