Butterfly Spread – An advanced Neutral Options Trading Strategy

Here, we will discuss in details about Butterfly Spread Options Trading Strategy. This is an advanced options strategy used during Neutral Market conditions.

About Butterfly Spread Options Trading Strategy

The Butterfly Spread is an advanced neutral trading strategy that involves both calls for a spread and put for spread transactions.

The setting up of the trade needs an initial investment. The risks of potential loss are pretty low but so are the chances for potential gains.

It follows a put and profit trading strategy that revolves around gaining benefits. It takes from a security deposit showing minimum price variations.

Besides, it is unsuitable for the beginners and works on a three-tier transaction called buy call / write call / buy call. It also involves upfront costs and requires medium to high-level expertise in the trade.

Objective of Butterfly Spread

The Butterfly Spread is a popular preference for traders who hold expertise in the domain, and an investor who has a deep knowledge of the market risks and the spikes and dips of the price variation.

The traders can use the strategy to gradually spread the trade gaining profits at lowered risks. Even if the prices move, the loss is less.

So considering a low or no movement in the market prices, one can expect profits. However, this requires a good knowledge of market behavior.

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Setting up The Butterfly Spread

Establishing a butterfly spread requires three major orders with the broker. The orders can be simultaneous or you can do it in one go. It helps to maximize the profits and minimize the upfront cost. These orders include;

• Buying in money calls,
• Buying out the exact amount of money calls, and
• Writing at least twice the money calls.

One should deal with contracts in a legal manner with an expiry date or a termination period and clause. The contracts can be to the nearest date. Now, this reduces the chances of a huge price fall which can result in potential loss.

Setting up a strike near to the recent trading prices lowers the upfront cost and also limits the profit amount. Doing the opposite might benefit the trader with huge profits but requires a greater upfront cost.

Butterfly Calls

The spread works in different modes of money calls which we popularly know as Butterfly calls. We have discussed some of the important Butterfly calls here.

Long Call Butterfly

It involves buying in-money calls at the low strike price and then writing the double of the money call options. It is about buying money calls at a higher strike price.

We can make profits if the underlying price remains in level with the calls after the contract termination. The maximum profit equals the strike of written calls less the strike of lower calls, premiums, and commissions included.

Short Call Butterfly

The short call is set up by selling money in call options at a lower price. It is possible to buy in a double at the money call option and then selling at higher strike prices.

Profits happen if the underlying price lies above the higher strike or below the lower strike. The maximum profit brings by the difference of the initial premium payments and the commissions paid.

Long Put Butterfly

The Long put is established by buying puts at lower prices. Then they sell the double with the money put and then buy the higher-priced puts.

Maximum profits happen if the underlying security remains leveled with the mid-strike prices. The maximum profit is by {higher strike price – (the strike of the sold put + the premium paid)}

Short Put Butterfly

The Short Put comes by writing out of the money puts at a low strike. It further happens by buying double at the money puts and writing in the money put option with the high strike price. We receive profits if the underlying security remains above the higher strike price.

It could also happen if they are below the lower strike price at the contract termination. The maximum profits are exactly the amount of premiums.

Iron Butterfly

The Iron Butterfly is created by buying an out of the money put at a lower strike, writing an at-the-money put, then writing an at the money call and buying in an out of the money call at the higher strike price.

Profits received of the underlying price remain at the mid-strike price. The maximum profit, in this case too, is the premiums we receive.

Reverse Iron Butterfly

The Reverse Iron Butterfly Spread works in a way opposite to the Iron Butterfly. An out of the money put at the lower strike price is written, an at-the-money put is bought.

It happens along with an at the money call and then an out of the money call at the higher strike price is written.

Any movement in underlying security above or below the lower strike price contributes to the trader’s profit. The maximum profit is given by {strike price of the written call – (the strike of the bought call + the premiums paid.)}

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Profit and Loss Potential Of Butterfly Spread Trading Strategy

The Butterfly Spread is more of a low-risk trading strategy that revolves mainly around earning profits from the initial investment or the security.

The potential losses are reduced if the market price at the time of contract expiration is around the price at the beginning of the contract. A steep slope towards the fall can cause huge losses to traders.

The Butterfly Spread mostly returns the profit to the trader regardless of the direction of the price fluctuation as there is subsequent buying and selling of the money calls.

However, if the fluctuations are obvious, the trader might have an impact depending upon the direction of the fluctuation.

The losses are major if the prices of the underlying security are moved too far in either direction. If the prices fall too sharply, all the money calls turn worthless.

This, in turn, leaves the trader with no returns and liabilities. Now, thus, all the money in the initial spread will bring a loss.

If the prices increase suddenly and show an unexpected hike, the in-calls show a subsequent price hike.

However, the written calls have equal impact and thus, the payments fall upon the upfront. This can cause a loss to the trader.

The trader can call of the call positions or terminate the contracts before the expiry date, if the trader sees a profit at the point of termination.

Variations of the Butterfly Strategy

The major butterfly variations include the call butterfly and the put butterfly. Another important variation of the strategy is Broken Wing Butterfly Spread. The Broken Wing Butterfly works in a slightly different manner than call and put.

In the Broken wing, the buying of out the money call options happens at a strike further away from the current price of the underlying security than in the money calls bought.

This greatly reduces the upfront cost and cuts down investment prices. It is popular as Skip Strike Butterfly Spread.

While using the broken wing strategy, if the transactions occur on call-basis, the losses are minimal if the prices of the underlying security fall but the risks are greater if the prices increase at the termination period.

If the transactions happen on a puts basis, the losses can be considerable if the prices of the underlying security amount fall but with the security prices, the losses are minimal to low giving away huge profits.

Find out more relevant Neutral Option Trading Strategy below

The Margin Requirements

The margin requirements for the butterfly spread trading are governed by the Regular T, known as Federal Reserve Board Regulation T.

However, the real deal falls at the brokers’ end as they can negotiate in and out and apply more stringent margins.

Risks Involved With Butterfly Spread

Being a short term neutral trading strategy, Butterfly Spread involves minimal to no risks and needs minimum loss management.

However, keeping in mind the expertise it demands, it can cause potential damage to the trade and finance to the novice investors.

High functional knowledge is what we need to carry out the complex in and out money call. We need it for the trade; else we could face potential losses.

Summing up the Butterfly Spread Options Strategy

The Butterfly Spread gives away profits to the investors if the underlying security deposit shows minimum or no movements in its price during the contract.

Studying the various options, a trader can set up butterfly contracts according to the time and money in hand.

Every variety has a different approach to making the transactions and there are simple ways to calculate the profit earned and risks involved.

These varieties come in handy in setting up the trades as per the choice of the investor to make maximum profits.

However, as the strategy is based on three-tier transactions, it requires a slightly greater upfront cost or initial investment than the other methods available.

Since the risk is minimum; it is one of the best options for traders who are ready to deal with complex trading strategies.

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