What Is a Butterfly Spread and When Is It Used? 

Key Takeaways

1. Butterfly options strategy utilizes four option contracts at three strike prices and may generate its maximum profit when the underlying asset finishes near the middle strike at expiry. 
2. The maximum risk is capped by the net amount of premium, making it a defined-risk strategy compared with naked option strategies.
3. However, butterflies spread is generally used when a trader expects the underlying to remain within a relatively narrow range and volatility is supposed to be low as well.
4. Some types of butterflies include long call butterfly, long put butterfly, and iron butterfly.
5. Some common mistakes include selecting the wrong middle strike price, lack of consideration of time decay of outer strikes, and having illiquid options.

If you've spent any time around options trading, you've noticed that most strategies fall into different market conditions. Some of them are used when traders expect a large price move while others are used when traders expect the market to remain within a range. A butterfly spread is one such strategy.  A butterfly spread can be used when a trader expects the underlying to remain within a range, while keeping the maximum loss defined.

This blog breaks down what a butterfly spread is, how it's built, and when traders may use it in  f&o trading.

What Is a Butterfly Spread?

A butterfly spread is an options trading strategy made up of four option contracts expiring on the same day. Its payoff structure forms a butterfly shape, hence its name.

The basic construction of a long butterfly spread in options involves three strikes:

• One buy option at the lower strike
• Two sell options at the middle strike
• One buy option at a higher strike

All four options have the same form; that is, they are all calls or all puts, and also expire on the same day. The strike in the middle is often set close to the expected settlement price of the underlying asset.

Because both an option purchase and sale will be involved, the net premium paid to enter the trade can be calculated at the time of execution. For a long butterfly spread, this net premium represents the maximum potential loss.

How a Butterfly Spread Works

A butterfly spread can be described as a trade consisting of three parts combined as one: the lower and higher strike options help limit the potential loss if the underlying moves significantly away from the middle strike. The two options sold at the middle strike form the centre of the strategy.

Profit maximization takes place when the price of the underlying expires at the middle strike level. Profit levels decrease as you move away from the point, and moving further results in the trade reaching its maximum loss, which equals the net premium paid for setting up the trade.

This structure gives the trader a defined maximum profit and maximum loss, which can be considered when using the strategy in the f&o market.

When Should Traders Use a Butterfly Spread?

1. When You Expect Low Volatility

The butterfly spread maybe used when a trader expects the underlying to remain within a tight range until expiry. For example, it may be considered when a stock or index is trading within a range and the trader expects this to continue.

2. Around Known Events That Are Already Priced In

The butterfly spread may be used by some traders after a specific event, such as results publication or policy implementation, is done, and the level of implied volatility has come down. The strategy may be considered when the trader expects the underlying to remain within a range after the event.

3. When You Want Defined Risk

As opposed to naked option selling, where there is a possibility of huge losses, in a butterfly spread, your losses are generally limited to the premium that you pay. This makes the defined risk an important feature of the strategy in options trading.

4. Defined Risk Compared With Straddle

Straddle selling can benefit when the market remains within a range, but it exposes one to unlimited risks if the underlying makes a large move. The butterfly spread strategy has a defined maximum loss, although its potential profit is also limited. This difference can be considered when comparing the two strategies in f&o trading.

Types of Butterfly Spreads

• Butterfly spread on calls: uses call options, and is generally used when the trader expects the underlying to be near the middle strike at expiry.
• Butterfly spread on puts: uses put options, and follows a similar structure, with the trader expecting the underlying to be near the middle strike at expiry.
• Iron butterfly: Uses both call and put options. It combines a short straddle at the middle strike with a long call and a long put at the outer strikes.

Commonality between the two is the fact that the profit is maximized around the middle strike and capped when moving away from it.

Common Mistakes Traders Make With Butterfly Spreads

• Picking the wrong middle strike. The maximum profit of the strategy occurs around the middle strike, so selecting a strike that is far from the expected price of the underlying can affect the potential outcome.
• Ignoring time decay on the wings. Time decay affects all the options in the strategy. Traders should consider how changes in time and option value may affect the spread as expiry approaches.
• Overlooking liquidity. Four legs need filling at reasonable prices. Illiquid options can have wider bid-ask spreads and may increase execution costs.
• Holding through unexpected volatility. A sudden market move triggered by an event may move the underlying away from the middle strike. This can affect the value of the butterfly spread before expiry.

How mastertrust Helps With Options Trading

A four-legged strategy involves multiple orders, so execution prices and slippage can affect the trade. mastertrust’s trading software provides tools for placing multi-leg options strategies and futures and option orders through the same window rather than chasing each leg of the butterfly spread.

As far as fees are concerned, mastertrust keeps things simple, that is, mastertrust charges Rs. 20/- per order for Stocks, F&O, and Commodity. There is also no account opening charge with mastertrust, and there is free demat AMC in the first year, and lifetime free demat AMC is also available by paying a small fee once.

Read more about account opening with mastertrust and explore mastertrust's F&O trading platform for details on margins and multi-leg order placement.

Final Thoughts

A butterfly spread is built for traders who have a view that the underlying will stay in a range, and who'd rather have an idea about their maximum loss before entering the trade. The middle strike, time to expiry and liquidity are important factors to consider when using a butterfly spread in options trading.

Frequently Asked Questions (FAQs)

1. Is a butterfly spread suitable for beginners in options trading?

A butterfly spread has a defined maximum loss, but it still involves multiple option contracts and strike prices. Anyone considering this strategy should understand how strike prices, expiry and time decay affect the position before trading it.

2. What is the maximum loss in a butterfly spread?

It's limited to the net premium paid to set up the position, known at the time of entry.

3. Can a butterfly spread be used in f&o trading on indices as well as stocks?

Yes, traders apply it to both index options and stock options, depending on where they see a range-bound opportunity.

4. How is an iron butterfly different from a regular butterfly spread?

An iron butterfly uses both calls and puts, combining a short straddle with a long strangle, while a standard butterfly uses only calls or only puts across three strikes.

5. Does a butterfly spread require a large margin?

The margin requirement depends on the type of butterfly, the contracts used, the broker and the applicable exchange requirements. Since the risk of a long butterfly is defined, the margin requirement may differ from that of an uncovered option position.