For the past few weeks, we’ve been discussing a few advanced options strategies. Today, we’ll discuss another advanced strategy that is a bit less common: the butterfly spread.

We first discussed options spreads here and here.

While a bit more complex, the butterfly spread is worth knowing, because it’s perfect for periods where a stock is not likely to fluctuate significantly. In that respect, the butterfly trade can change what would normally be an unprofitable trading period for the stock into a profitable one.

Let’s dive in to learn more.

How A Butterfly Spread Works

As mentioned, traders often use the butterfly strategy when they feel a particular stock will remain neutral during a specific period. By entering into a butterfly trade, the trader is essentially betting that the underlying stock price will remain close to where it is currently.

This trade requires three separate positions (four total contracts) and is a bit more complex than the collar. It can be made using either put options or call options. For simplicity, we will use calls in this example.

To execute this trade, you will need to buy two calls — one at a low strike price and one at a higher strike price. You also need to sell two options with strike prices at or near the current price.

Here’s an example of how it works…

Let’s say you believe that XYZ, which is trading at $100, will remain relatively unchanged during the next month. To take advantage of this (while also wanting to limit downside risk), you want to set up a butterfly trade.

To do this, you buy one XYZ 95 call for $6 and one XYZ 105 call for $1. You will also sell two XYZ 100 calls for $3 each. The net result of these positions will be a cost of just $1:

A butterfly trade may seem complicated at first glance due to the multiple options positions required to construct it. However, a quick look at the diagram below should make the payoff relatively easy to understand.

In this example, the trader obtains the maximum payoff when the stock finishes at $100. As XYZ’s price moves further and further from $100 in either direction, the trade begins to lose value. When the price reaches (or moves beyond) $95 or $105, the trade leads to a maximum loss of $1.

This diagram clearly shows just how accurate you must be at forecasting XYZ’s future stock price to reap a profit from the trade. If the outcome does not go according to plan, however, the worst that can happen is the trader loses $1, no matter how high or low the price goes.

Closing Thoughts

Ultimately, this trade will pay the maximum amount if the stock finishes at the middle strike price. The trade has minimal downside risk, but you must estimate the correct future stock price to a relatively narrow range to make the trade profitable.

Again, the butterfly should only be used in very specific situations. However, when used effectively, it can be quite profitable.

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