Butterfly Spreads

A butterfly is a volatility bet that the trader can implement to protect against large fluctuations, or to gain on volatility. You will notice that a butterfly is almost like a straddle, with a difference in the edges. The traders can add additional contracts to his/her strategy to reduce the risk of large losses or gains for more protection.  A butterfly can be executed in different ways: with puts only, calls only, or a mix of both.

What are its components?

A long butterfly can be created in three ways:

  • Butterfly with puts only
    • Buy Put at strike price 1
    • 2 x Sell Put at strike price 2
    • Buy Put at strike price 3
  • Butterfly with calls only
    • Buy Call at strike price 1
    • 2 x Sell Call at the strike price 2
    • Buy Call at strike price 3
  • Butterfly with puts and calls
    • Buy Put at strike price 1
    • Sell Put at strike price 2
    • Sell Call at strike price 2
    • Buy Call at strike price 3
  • (*A short butterfly can be created by implementing the reverse strategies above)

When and why should I have a butterfly?

You should have a butterfly if you expect to see a lot of fluctuation in the underlying asset’s price. Creating a butterfly does not infer that you have a specific view on the stock. It simply implies that the trader expects a lot of volatility and executed a strategy to gain something from it. You can create a short butterfly if you do not expect any fluctuations.

What does it look like graphically? What is the payoff and profit graph?

What is the break-even point?

The break-even point of a butterfly can be defined by finding the stock price where the butterfly generates a zero-dollar profit. By adding all contracts and equating it to zero, you should solve for ST. However, there is a possibility where a region of stock prices can break-even. To find this region, you should create scenarios to define the payoffs. For example, the payoff when ST<30, 30<ST<40, 40<ST<50 and 50<ST.

About Kevin Smith

Kevin is the content manager for Personal Finance Lab and is from Chicago, Illinois. He has a Master's Degree in Economics from Concordia University in Montreal, Canada. In addition to an economics background, he has also built training manuals to prepare finance companies for licensing requirements in mortgage loan origination and insurance sales.