A butterfly spread option is a sort of options trading in India technique that entails purchasing and selling call or put options at three various strike prices, creating a position with a limited risk and limited gain. The profit and loss graph of the positions resembles the structure of a butterfly with wings, hence the name “butterfly” spread for the trading method. While setting up a butterfly spread option, a trader would:
- Purchase a single call (or put) option with a strike price lower than the going rate.
- Sell two calls (or puts) with a strike price equal to the going rate.
- Purchase a single call (or put) option with a strike price higher than the price on the market.
The outcome is a net debit spread, which means that the premium earned from the short options is less than the cost of the long options. If the price of the underlying asset is at the strike price at expiration, the butterfly spread option’s maximum profit potential is realised.
The maximum loss is capped at the position’s initial investment. When an investor anticipates that the price of an underlying asset will be relatively steady in the near future but also wants to limit their potential losses in case the price moves considerably in either direction, they frequently use butterfly spreads. Depending on whether calls or puts are employed, they can be used in both bullish and bearish market scenarios.
What are the Different Types of Butterfly Spread Options?
Options for the butterfly spread can take several different shapes:
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The Long-Call Butterfly
These spreads are entered by investors when they believe the underlying stock price won’t change at expiration. Traders that use this strategy:
- Purchase 1 call option at a cheaper strike price.
- Sell two calls with the intermediate strike price.
- Purchase one call at a higher strike price.
The underlying stock and expiration date are identical for all call options. If the security price on the expiration date is equal to the middle strike price, the investors earn the most.
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Butterfly in a Short Call
Traders who employ this butterfly strategy:
- One call option should be sold at a lower strike price.
- Purchase two calls with the intermediate strike price.
- One call should be sold at a higher strike price.
If the security price at expiration is more than the higher strike price or lower than the lower strike price, investors can maximise their profit.
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The Long Put Butterfly
Investors engage in this butterfly spread when they:
- Purchase 1 put at a cheaper strike price.
- With the middle strike price, sell two puts.
- Purchase 1 put at a premium strike price.
When the security price on the expiration date is equal to the middle strike price, investors profit the most.
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The Short Put Butterfly
The butterfly short put is created when investors:
- With a lower strike price, sell 1 put.
- Purchase two puts at the middle strike price.
- Sell one put at a more expensive strike price.
Whether the price of the asset is greater than the higher strike price or lower than the lower strike price on the expiration date, traders can benefit the most.
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An Iron Butterfly
Investors that use this method buy and sell a mix of call and put trades. They work in the following professions:
- Purchase 1 put at a cheaper strike price.
- At a middle strike price, sell one put.
- With a middle strike price, sell 1 call.
- Purchase one call at a higher strike price.
When the price of the underlying security is identical to the middle strike price at expiration, traders benefit the most.
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Iron Butterfly in Reverse
The reverse or short iron butterfly is a method with constrained risk and potential reward. When the underlying securities are projected to move sharply either higher or downward, investors employ it. It develops when investors:
- Sell one put at a reduced strike price.
- Purchase one put at the intermediate strike price.
- Purchasing 1 call with a medium strike price.
- Sell 1 call with a more expensive strike price.
The security price must be more than the lower strike price and less than the higher strike price on expiration in order to generate the highest profit.
An Example of Butterfly Spread Options
Call Butterfly Spread Option
Let’s say a company’s stock currently trades for Rs. 1000. A stockholder decides to exercise a call butterfly spread option with the strike prices and premiums listed below because they anticipate the stock price to remain stable or increase moderately in the near future.
- Purchase 1 call option at 950 rupees with a 60 rupee premium.
- Sell two call options with a Rs. 1000 strike price each for a Rs. 30 premium.
- Purchase 1 call option at 1050 rupees with a 10 rupee premium.
This position has a net negative of Rs. 50 (60 – 30 – 30 + 10). If the stock price is exactly Rs. 1000 at expiration, the highest profit potential is Rs. 150, and the maximum loss is Rs. 50. (the initial cost of the position).
Conclusion
A butterfly spread is an option for trading that consists of various options on the same company’s stock with the same expiration but different strike prices. It is a limited risk investment technique with a finite profit. To execute four trades in all, three strike prices are needed. The option for the investors to select four call options, four put options, or a combination of both is available if you use the best stock market app.
