Understanding the Butterfly Strategy in Options Trading

Financial derivative conferring the right to to buy or sell a certain thing at a later date at an agreed price.

The Butterfly Strategy is a neutral options strategy that involves a combination of various options contracts. This strategy is designed to profit from low volatility in the underlying asset while limiting the potential risk.

What is the Butterfly Strategy?

The Butterfly Strategy involves four options contracts with the same expiration date but different strike prices. It is constructed by:

• Buying one in-the-money call option (lower strike price)
• Selling two at-the-money call options (middle strike price)
• Buying one out-of-the-money call option (higher strike price)

The same can be done with put options. The strategy gets its name from the payoff diagram, which resembles a butterfly.

When to Use the Butterfly Strategy

The Butterfly Strategy is typically used when a trader has a neutral outlook on the market, expecting the price of the underlying asset to remain relatively stable until the options expire. It is a limited risk, limited reward strategy.

Setting Up a Butterfly Spread

Here's a step-by-step guide on how to set up a Butterfly Spread using call options:

1. Buy an In-The-Money Call: This is the call option with a strike price below the current market price of the underlying asset.
2. Sell two At-The-Money Calls: These are call options with a strike price equal to the current market price of the underlying asset.
3. Buy an Out-Of-The-Money Call: This is the call option with a strike price above the current market price of the underlying asset.

The net effect of these transactions is to create a "spread" with limited loss and limited profit potential.

Real-Life Example of Butterfly Strategy

Let's say a stock is trading at $50. A trader could set up a butterfly spread by:

• Buying a 45 call for 6.00
• Selling two 50 calls for 2.00 each
• Buying a 55 call for 1.00

The total cost of this trade would be 3.00 (6.00 - 4.00 + 1.00). This is the maximum loss. The maximum profit would be 2.00, which would occur if the stock is at 50 at expiration.

In conclusion, the Butterfly Strategy is a sophisticated strategy that can be used to profit from low volatility. It requires a good understanding of options trading but can be a useful tool in the right circumstances.