What Is Butterfly In Options Trading

Options Trading
189 Views

Options traders can profit from non-directional market movements using butterfly strategies. With this strategy, you get a balanced risk-reward scenario with capped profit potential by combining elements of both bull and bear spreads. The Butterfly Strategy aims to establish a stable price range by using four option contracts with the same expiration date but at three different strike prices. Here’s a look at the Butterfly Strategy, its types, and its advantages and disadvantages.

What Is Butterfly In Options Trading?

Often referred to as “fly,” the Butterfly in options trading is a risky, non-directional strategy designed to encourage good profits for investors. In this situation, the future volatility of the underlying asset may be higher or lower than its present implied volatility.

Basically, it combines both the bear and bull spreads of an asset with a limited or specified risk and capped profit. The strategy is efficient with a maximum payoff if the asset fails to move before the options expiration.

How Does Butterfly Options Strategy Work?

The butterfly options strategy involves using four options contracts with the same expiration date but at three different strike prices. Here, the goal is to create a stable range of prices to potentially make profits.

In simple terms, butterfly options work as follows:

The trader buys two option contracts:

  • One contract at a higher strike price.
  • Another contract at a lower strike price.

At the same time, the trader sells two option contracts:

  • One contract at a strike price in between the higher and lower strike prices (the middle strike price).
  • The middle strike price is determined by the difference between the high and low strike prices of the same underlying asset.

The butterfly strategy works best when the market isn’t expected to be very volatile (non-directional). This allows the trader to aim for a specific expected profit while controlling their risk.

The ideal outcome of the butterfly strategy is when it’s close to the expiration date, and the underlying asset’s price matches the middle strike price. The butterfly options strategy can easily be implemented by buying and selling the required options contracts using a futures and options app.

Types Of Butterfly In Options Trading

Here are the types of butterfly options strategy:

Long Call Butterfly Spread

This strategy involves buying one in-the-money call option with a lower strike price, writing two at-the-money or medium strike price call options, and then purchasing one out-of-the-money call option with a higher strike price. It creates a net debit and aims to maximize profit when the underlying asset’s price matches the written calls at expiration.

Short Call Butterfly Spread

In this strategy, traders buy two at-the-money call options, sell two out-of-the-money call options, and then sell one in-the-money call option with a lower strike price. It generates a net credit and seeks to profit when the underlying asset’s price is below the lower strike or above the upper strike at expiration.

Long Put Butterfly Spread

This spread involves buying a put with a lower strike price, selling two at-the-money puts, and then buying a put with a higher strike price. It results in net debt and aims to achieve maximum gain if the underlying asset’s price remains at the intermediate strike price.

Short Put Butterfly Spread

Traders write one out-of-the-money put option with a lower strike price, buy two in-the-money puts, and then write an in-the-money put option with a higher strike price. The strategy’s maximum profit is achieved if the underlying price falls below the lower strike or rises above the upper strike at expiration.

Iron Butterfly Spread

This spread entails buying an out-of-the-money put with a lower strike price, selling an in-the-money put, writing an in-the-money call, and purchasing an out-of-the-money call with a higher strike price. It is most effective in low-volatility conditions and generates a net credit.

Reverse Iron Butterfly Spread

This strategy involves creating an out-of-the-money put at a lower strike price, buying an at-the-money put, writing an out-of-the-money call, and purchasing an at-the-money call with a higher strike price. It results in a net negative trade and performs well in high-volatility situations, with maximum profit achieved if the underlying price moves below or above the lower or upper strike prices.

Advantages Of The Butterfly Strategy

Here are the main advantages of using the butterfly strategy in option trading.

Defined Risk

Since the maximum loss is limited to the initial trade cost, the Butterfly Strategy offers limited risk exposure.

Profit Potential

For uncertain market conditions, the strategy allows for potential profits in a non-directional market.

Versatility

By choosing the right strike prices and options contracts, traders can adapt the Butterfly Strategy to different market scenarios and volatility levels.

Disadvantages Of The Butterfly Strategy

The following are the two main disadvantages of the butterfly strategy

Commissions And Fees

The Butterfly Strategy may result in higher transaction costs because of multiple options contracts.

Limited Profit

While the strategy offers defined risk, it’s also limited in profit potential.

Conclusion

Using the Butterfly Strategy in options trading allows you to profit from non-directional movements in the market. Combining bull spreads and bear spreads, it offers a balanced risk-reward with capped profits. Traders use four option contracts at three different strike prices to create a stable price range. With Share India, a leading financial services company, you can use the Butterfly Strategy and explore options trading. Share India’s expertise lets investors navigate options trading confidently and optimize their strategies.

Leave a Reply

Your email address will not be published. Required fields are marked *