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In summary
A butterfly option strategy combines four option contracts with the same expiry date and three different strike prices. The strategy aims to benefit when the underlying asset remains close to the middle strike price at expiry.
Key points:
- Uses one ATM option, two OTM options, and one further OTM option.
- Can be created using call options, put options, or an iron butterfly structure.
- Works best when the underlying asset experiences limited price movement.
- Has defined risk and defined profit potential.
- Requires four option contracts and three strike prices with the same expiry date.
- Maximum profit is generally achieved when the underlying asset closes at or near the middle strike price at expiry.
- Commonly used in the futures and options (F&O) segment by traders with a neutral market outlook.
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What is the butterfly option strategy
How do ITM, OTM and ATM options differ?
A butterfly option strategy is an options trading strategy used when a trader expects the price of an underlying asset to remain within a limited range. It combines multiple call or put options with the same expiry date but different strike prices.
The strategy is designed to offer limited risk and limited reward. It is commonly used in futures and options trading when traders expect low volatility.
Understanding the key components
| Component | Meaning |
| ATM option | An at-the-money option with a strike price closest to the current market price |
| OTM options | Out-of-the-money options sold above and below the ATM strike |
| Further OTM option | An additional purchased option with a strike price farther away from the current price of the underlying asset than the two sold options. |
Basic structure of a butterfly spread
| Step | Action |
| Step 1 | Buy one ATM call or put option |
| Step 2 | Sell two OTM call or put options |
| Step 3 | Buy one further OTM call or put option |
All contracts generally share the same expiry date.
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How does butterfly options strategy work?
A butterfly spread is created using four option contracts and three strike prices.
The standard long butterfly structure involves:
| Step | Action |
| Step 1 | Buy one option at a lower strike price |
| Step 2 | Sell two options at the middle strike price |
| Step 3 | Buy one option at a higher strike price |
The strategy benefits when the underlying asset remains close to the middle strike price. If the asset moves sharply higher or lower, profit potential decreases and losses may occur, although risk remains defined.
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Types of butterfly option strategy
- Long call butterfly spread
A long call butterfly spread involves:
- Buying one call option at a lower strike price
- Selling two call options at the middle strike price
- Buying one call option at a higher strike price
This strategy is commonly used when limited price movement is expected. Maximum profit occurs when the underlying asset expires near the middle strike price.
2. Long put butterfly spread
A long put butterfly spread follows the same structure but uses put options instead of call options.
The strategy benefits when the underlying asset remains close to the middle strike price at expiry. The maximum loss is generally limited to the net premium paid.
3. Short call butterfly spread
A short call butterfly spread reverses the long call butterfly structure:
- Sell one lower strike call
- Buy two middle strike calls
- Sell one higher strike call
This strategy is generally used when a trader expects higher volatility and a significant price move away from the middle strike price.
4. Short put butterfly spread
A short put butterfly spread mirrors the short call butterfly but uses put options.
It is typically used when the trader expects substantial movement in the underlying asset before expiry.
5. Iron butterfly
An iron butterfly combines call and put options.
| Position | Action |
| ATM call | Sell |
| ATM put | Sell |
| Higher strike call | Buy |
| Lower strike put | Buy |
The strategy is commonly used when limited price movement is expected.
6. Reverse iron butterfly
A reverse iron butterfly is the opposite of an iron butterfly.
| Position | Action |
| ATM call | Buy |
| ATM put | Buy |
| Higher strike call | Sell |
| Lower strike put | Sell |
This strategy is generally used when significant price movement is expected in either direction.
Unlike the original source article, a reverse iron butterfly does not provide unlimited profit or unlimited loss potential. Both profit and loss are typically defined by the strike price structure and net premium.
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Example of a butterfly option strategy
Assume XYZ Ltd. is trading at ₹1,000 per share and a trader expects the stock to remain within a narrow range until expiry.
The securities quoted are for example purposes only and not a recommendation.
How is the butterfly spread created?
| Position | Strike price |
| Buy 1 call option | ₹1,000 |
| Sell 2 call options | ₹1,050 and ₹1,100 |
| Buy 1 call option | ₹1,150 |
What happens under different market scenarios?
Scenario 1: Price remains between ₹1,000 and ₹1,100
If XYZ Ltd. remains within this range, the butterfly spread can generate a profit.
Maximum profit is generally achieved when the asset expires near the middle strike price.
Scenario 2: Price rises above ₹1,100
If the stock moves significantly above the upper strike prices, losses may occur.
However, the purchased options help limit the overall loss.
Scenario 3: Price falls below ₹1,000
If the stock falls below the lower strike price, losses may occur.
The maximum loss remains limited because of the defined-risk structure.
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What are the common butterfly spread variations?
Butterfly spreads are a family of options trading strategies. There are several variations of butterfly spreads, each with its unique characteristics and applications. Let us explore some of the common types:
| Strategy | Structure | Typical market view |
| Long call butterfly | Calls only | Low volatility |
| Long put butterfly | Puts only | Low volatility |
| Short call butterfly | Calls only | High volatility |
| Short put butterfly | Puts only | High volatility |
| Iron butterfly | Calls and puts | Low volatility |
| Reverse iron butterfly | Calls and puts | High volatility |
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Conclusion
A butterfly option strategy is a defined-risk options trading strategy used in the futures and options (F&O) market. It combines four options contracts across three strike prices and is generally suitable when a trader expects the underlying asset to trade within a limited price range until expiry.
Variations such as long butterfly spreads, short butterfly spreads and iron butterflies can be used to reflect different volatility expectations. Before trading futures and options, traders should understand the strategy's payoff structure, risk limits and expiry-related outcomes.
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Frequently Asked Questions
Butterfly Option Strategy
What are the diverse forms of butterfly spread options?
Butterfly spread options come in several forms based on the instruments used and market expectations. These include the long call butterfly, short call butterfly, long put butterfly, and short put butterfly. Each variation involves three strike prices and different combinations of buying and selling options to suit bullish, bearish, or neutral outlooks.
How to distinguish between a straddle and a butterfly spread?
A straddle involves buying or selling both a call and a put option with the same strike price and expiration, aiming to profit from large price movements. In contrast, a butterfly spread uses three strike prices and is designed to profit from low volatility, offering limited risk and return within a specific price range.
When must I purchase a short call butterfly?
A short call butterfly is typically purchased when you expect low volatility and minimal price movement in the underlying asset. This strategy benefits from time decay and generates maximum profit if the asset price remains outside the breakeven range or experiences a sharp move beyond the outer strike prices.
Can I incur loss in a long call butterfly?
Yes, losses can occur in a long call butterfly if the underlying asset's price moves significantly beyond the breakeven points at expiry. While the strategy limits both maximum profit and loss, it is most effective when the asset stays near the middle strike price, making precise forecasting essential.
When is the highest profit achieved from a long call butterfly?
The maximum profit is achieved if the price of the underlying asset is equal to the middle strike price at expiration.
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