Butterfly Option Strategy Overview

The butterfly is an option strategy that a trader might use when they believe that the underlying security will see little change in its price.  This range trading strategy is a complex option position, consisting of three option legs and two primary embedded option positions.

A long butterfly position is constructed from all call options or, alternatively, all put options.  The position involves selling two option contracts at a given strike, while also buying one contract at a higher strike and a second contract at a lower strike.

Because you are long two options, both short options are covered.  As such, this is a limited risk trade.

For example, we have created a butterfly using the SPYder ETF, which is trading at $133 per share.  The butterfly position was constructed by selling two $133 strike call options, while buying one $131 call and one $135 call option.

The graphic above demonstrates the risk graph for our butterfly position.  You will note that there is a narrow range in which a profit will be realized.  The maximum risk is quite limited, however. 

These trades are typically placed for a small debit, which represents their maximum risk.  If you were to open the position for a net credit, you would have a guaranteed profit equal the amount of the credit.  You can see from the graphic above that this position's maximum risk is less than $50, while offering a maximum profit of more than $150 at expiration.

Embedded Positions With The Butterfly

You will also find that you are essentially long one bull call spread, i.e., long the $50 call and short the $55 call, and short one bear call spread, i.e., short the $55 call and long the $60 call.  These are your primary embedded positions.

Once you appreciate the nature of the embedded positions, you will find that if you are now able to efficiently adjust vertical spreads. 

Adjusting Into A Butterfly Trade

For example, assume you buy a bull call spread for a $1.00 debit.  After opening your debit spread, the market moves favorably and you now expect the market to consolidate at current price levels.  If you close your spread now, you will realize a small profit but if the consolidation breaks down you risk a loss.

One possible solution may be to sell a bear call spread by selling the same short strike in your bull call spread while simultaneously buying a higher strike.  Assume you receive a $1.50 credit. 

By opening the bull call spread, you have rolled into a butterfly position for a net credit of $.50.  That credit represents a guaranteed profit. 

If the market remains between the strikes of your long options, you may enjoy additional profits.  Your adjustment has eliminate the risk of loss, while still preserving the opportunity for additional profits.

Learning How To Use Butterflies In Your Trading

The butterfly is a complex position, that has more uses than those outlined here.  Many professional traders favor these positions for several reasons and use them to control risk while still generating meaningful profits.

These strategies do require some additional insight that you can only gain by studying how the position works and how to incorporate it into your option trading arsenal.

Recommendations for Further Study

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