Compositedge E-learning- Butterfly spreads

Butterfly spread strategies are a combination of a bull and bear spread, effectively making it a low-cost neutral strategy. The strategy typically comprises of a combination of three strike prices using a combination of either calls or puts having the same expiry with limited risk and profit potential. Butterfly spreads are categorized into two types

Long butterfly-Generally used if you’re anticipating prices of the underlying to remain in a narrow range until the expiry of the contract.

Short butterfly-This strategy is employed if you’re expecting prices of the underlying to breakout beyond the highest or lowest strikes.

Let’s analyse all the butterfly spread strategies beginning with

Long Butterfly spread with calls-

The strategy comprises of BUYING two calls at different strike prices and SELLING two calls at an identical strike price, resulting in net debit.
A typical long call butterfly spread strategy is illustrated below
Buy one IN THE MONEY call
Sell two AT THE MONEY calls
Buy one OUT OF THE MONEY call

Payoff-

Source: Compositedge- Protrader terminal

The payoff for a long-call butterfly spread is highlighted below
Max profit:Difference between the premium paid for IN THE MONEY call and the premium received for AT THE MONEY call - net debit - commissions.
Max profits are achieved when the price of the underlying is at the strike price of the short call.

Max loss: Net premium paid + commissions.
Max loss arises when the price of the underlying goes beyond the strikes of the long IN THE MONEY or OUT OF THE MONEY calls.

Breakeven point: Occurs at the strike price of IN THE MONEY or OUT OF THE MONEY calls +/- net premium paid.

 

Long Butterfly spread with puts-

The strategy comprises of BUYING two puts at different strike prices and SELLING two puts at an identical strike price, resulting in net debit.
A typical long put butterfly spread strategy is illustrated below
Buy one IN THE MONEY put
Sell two AT THE MONEY puts
Buy one OUT OF THE MONEY put

Payoff-

Source: Compositedge- Protrader terminal

The payoff for a long-put butterfly spread is highlighted below
Max profit: Difference between the premium paid for IN THE MONEY put and the premium received for AT THE MONEY put - net debit- commissions.
Max profits are achieved when the price of the underlying is at the strike price of the short put.>

Max loss: Net premium paid + commissions.
Max loss arises when the price of the underlying goes beyond the strikes of the long IN THE MONEY or OUT OF THE MONEY puts.

Breakeven point: Occurs at the strike price of IN THE MONEY or OUT OF THE MONEY puts +/- net premium paid.

 

Short Butterfly spread with calls-

The strategy comprises of BUYING two calls at different strike prices and SELLING two calls at an identical strike price, resulting in net credit.
A typical long call butterfly spread strategy is illustrated below
Sell one IN THE MONEY call
Buy two AT THE MONEY calls
Sell one OUT OF THE MONEY call

Payoff-

Source: Compositedge- Protrader terminal

The payoff for a short call butterfly spread is highlighted below
Max profit: Net premium received - commissions
Max profits are achieved when the price of the underlying is <= short IN THE MONEY calls or >= short OUT OF THE MONEY calls.

Max loss: Difference between the premium paid for AT THE MONEY calls and the premium received for OUT OF THE MONEY call - net premium received + commissions.
Max loss occurs when the price of the underlying is at the strike price of the long call.

Breakeven point: Occurs at the strike price of IN THE MONEY or OUT OF THE MONEY calls -/ + net premium paid.

 

Short Butterfly spread with puts-

The strategy comprises of SELLING two puts at different strike prices and BUYING two puts at an identical strike price, resulting in net credit.
A typical long put butterfly spread strategy is illustrated below
Sell one IN THE MONEY put
Buy two AT THE MONEY puts
Sell one OUT OF THE MONEY put

Payoff-

Source: Compositedge- Protrader terminal

The payoff for a short put butterfly spread is highlighted below
Max profit: Net premium received - commissions
Max profits are achieved when the price of the underlying is <= short IN THE MONEY puts or >= short OUT OF THE MONEY puts.

Max loss: Difference between the premium paid for AT THE MONEY puts and the premium received for OUT OF THE MONEY put - net premium received + commissions.
Max loss occurs when the price of the underlying is at the strike price of the long put.

Breakeven point: Occurs at the strike price of IN THE MONEY or OUT OF THE MONEY puts -/ + net premium paid.

 

Compositedge, incorporated in 1995, is a leading discount broker and provider of algo trading solutions for retail customers in India. Headquartered in Bangalore, we provide the internationally acclaimed Protrader platform which comprises of charts, scalper, matrix, grid, time & sales, market-depth and options master in addition to the state of the art algo trading platform. We combine discount broking and algo trading solutions to ensure all our retail clients experience the finest trading amenities at affordable costs.