Butterfly spreads

Butterfly spreads are complex spreads that involve four or more contracts. We’ll cover these two strategies in this chapter:

• Butterfly spreads
• Iron butterfly spreads

Butterfly spreads

A typical butterfly spread involves four legs, of which three are unique. For example:

Long 1 ABC Jan 40 call at $13
Short 2 ABC Jan 50 calls at $5
Long 1 ABC Jan 60 call at $1

ABC’s market price = $48

When establishing this strategy, the investor incurs a $4 debit ($400 overall). Let’s break down this example through three possible market prices/ranges at expiration:

If ABC’s market price falls to $40 or below
At $40, the long 40 call is “at the money,” and the other contracts are “out of the money” with no intrinsic value. If ABC’s market price falls below $40, all contracts are “out of the money.” Regardless of the scenario, all contracts will assumptively expire worthless. The investor’s initial debit of $400 represents their overall loss.

If ABC’s market price rises to $50
The long 40 call is “in the money” by $10. All the other contracts are either “at” or “out of the money” with no intrinsic value and will assumptively expire worthless. Netting the $400 initial debit against the $1,000 made on the long 40 call ($10 intrinsic value x 100 shares per contract) results in a net $600 gain. This is the strategy’s maximum gain.

If ABC’s market price rises to $60 or above
At $60, the long 40 call is “in the money” by $20 and the two short 50 calls are “in the money” by $10. The intrinsic values of these three options offset* to no gain or loss. The long 60 call is “at the money” with no intrinsic value and will assumptively expire worthless. Even if ABC rises above $60, the options continue to offset each other. For every $1 in intrinsic value gains obtained by the long calls, the short calls experience $1 in intrinsic value losses. Whether ABC is at $60 or any price above, the investor is stuck with their initial debit, representing a $400 loss. This is the strategy’s maximum loss.

*Remember, intrinsic value represents gain for long contracts and loss for short contracts.

The strategy’s sentiment
The investor bet ABC’s market price will stay close to $50. As we discussed above, the investor reaches the maximum gain of $600 when ABC is at $50. The further the market price moves away from $50, the more likely the investor experiences a loss. Even if this occurs, the investor is subject to a maximum loss of $400. Therefore, this butterfly spread maintains a flat/neutral sentiment with limited loss and gain potential.

Let’s look at another butterfly spread with a different sentiment:

Short 1 XYZ Mar 30 put at $1
Long 2 XYZ Mar 35 puts at $3
Short 1 XYZ Mar 40 put at $8

XYZ’s market price = $34

When establishing the strategy, the investor obtains a $3 credit ($300 overall). Let’s break down this example through three possible market prices/ranges at expiration:

If XYZ’s market price falls to $30 or below
At $30, the short 40 put is “in the money” by $10 and the two long 35 puts are “in the money” by $5. The intrinsic values of these three options offset to no gain or loss. The short 30 put is “at the money” with no intrinsic value and will assumptively expire worthless. If XYZ falls below $30, the options continue to offset each other. For every $1 in intrinsic value gains obtained by the long puts, the short puts experience $1 in intrinsic value losses. Whether XYZ is at $30 or any price below, the investor is stuck with their initial credit, representing a $300 gain. This is the strategy’s maximum gain.

If XYZ’s market price rises to $35
The short 40 put is “in the money” by $5. All the other contracts are either “at” or “out of the money” with no intrinsic value and will assumptively expire worthless. Netting the $300 initial credit against the $500 lost on the short 40 put ($5 intrinsic value x 100 shares per contract) results in a net $200 loss. This is the strategy’s maximum loss.

If XYZ’s market price rises to $40 or above
At $40, the short 40 put is “at the money,” and the other contracts are “out of the money” with no intrinsic value. If XYZ’s market price rises above $40, all contracts are “out of the money.” Regardless of the scenario, all contracts will assumptively expire worthless. The investor’s initial credit of $300 represents their overall gain.

The strategy’s sentiment
The investor bet XYZ’s market price will be volatile, either falling to $30 or below, or rising to $40 or above. The closer the market price stays to $35, the more likely the investor experiences a loss. Even if this occurs, the investor is subject to a maximum loss of $200. Therefore, this butterfly spread maintains a volatile sentiment with limited loss and gain potential.

Iron butterfly spreads

An iron butterfly spread is similar to a straddle strategy, but with added elements. There are two types:

• Long iron butterfly spreads
• Short iron butterfly spreads

Long iron butterfly spread

A long iron butterfly spread is similar to a long straddle strategy, but includes two “out of the money” short options to reduce establishment costs. For example:

Short 1 BCD Jul 60 put at $1
Long 1 BCD Jul 70 put at $4
Long 1 BCD Jul 70 call at $4
Short 1 BCD Jul 80 call at $1

BCD’s market price = $70

As a reminder, a long straddle consists of a long call and long put with the same strike price and expiration. A long straddle would exist if the two $70 strike price contracts were extracted together. A $800 total debit would be incurred if the investor only traded these two contracts. The sale of the 60 put and the 80 call bring in $200 in premiums, reducing the overall cost of this long iron butterfly spread to $600.

Maximum gain
Like a long straddle, the investor is seeking volatility. Best-case scenario, BCD’s market price falls to $60 or rises to $80. If BCD falls to $60, the long put is “in the money” by $10, or $1,000 overall ($10 x 100 shares per contract). Netting this intrinsic value gain against the initial $600 debit results in a $400 gain. If BCD rises to $80, the long call is “in the money” by $10, or $1,000 overall ($10 x 100 shares per contract). Netting this intrinsic value gain against the initial $600 debit also results in a $400 gain. Therefore, $400 is the strategy’s maximum gain.

The two short options limit the investor’s gain potential. If BCD’s market price falls below $60, the long 70 put’s intrinsic value gains are offset by the short 60 put’s intrinsic value losses. If BCD’s market price rises above $80, the long 70 call’s intrinsic value gains are offset by the short 80 call’s intrinsic value losses. In either circumstance, the investor makes the maximum gain of $400.

Breakeven
The investor must obtain a return equal to the $600 initial net debit to break even. Long iron butterfly spreads have two breakeven points because a return can be made in either direction (in a bear or bull market). If BCD’s market price falls to $64, the long 70 put is $6 “in the money,” providing an intrinsic value gain of $600 ($6 intrinsic value x 100 shares per contract). If BCD’s market price rises to $76, the long 70 call is $6 “in the money,” providing an intrinsic value gain of $600. Both scenarios offset the original $600 net debit, so the investor will break even at $64 or $76.

Maximum loss
The investor loses when the market stays flat. All contracts will assumptively expire with no intrinsic value if BCD’s market price stays at $70. If this occurs, the investor is stuck with their initial net debit, resulting in a $600 maximum loss.

Short iron butterfly spread

A short iron butterfly spread is similar to a long straddle strategy, but includes two “out of the money” long options to reduce risk. For example:

Long 1 MNO Sep 100 put at $2
Short 1 MNO Sep 105 put at $3
Short 1 MNO Sep 105 call at $3
Long 1 MNO Sep 110 call at $1

MNO’s market price = $104

As a reminder, a short straddle consists of a short call and short put with the same strike price and expiration. A short straddle would exist if the two $105 strike price contracts were extracted together. A $600 total credit would be obtained if the investor only traded these two contracts. The purchase of the 100 put and the 110 call costs in $300 in premiums, reducing the overall credit of this short iron butterfly spread to $300.

Maximum gain
Like a short straddle, the investor gains when the market stays flat. All contracts will assumptively expire with no intrinsic value if MNO’s market price stays at $105. If this occurs, the investor keeps with their initial net credit with no further actions taken, resulting in a $300 maximum gain.

Breakeven
The investor must lose an amount equal to the $300 initial net credit to break even. Short iron butterfly spreads have two breakeven points because a loss can be incurred in either direction (in a bear or bull market). If MNO’s market price falls to $102, the short 105 put is $3 “in the money,” providing an intrinsic value loss of $300 ($6 intrinsic value x 100 shares per contract). If MNO’s market price rises to $108, the long 105 call is $3 “in the money,” providing an intrinsic value gain of $300. Both scenarios offset the original $300 net credit, so the investor will break even at $102 or $108.

Maximum loss
The investor is loses if volatility occurs. Worst-case scenario, MNO’s market price falls to or below $100 or rises to or above $110. If MNO falls to $100, the short put is “in the money” by $5, or $500 overall ($5 x 100 shares per contract). Netting this intrinsic value loss against the initial $300 credit results in a $200 loss. If MNO rises to $110, the short call is “in the money” by $5, or $500 overall ($5 x 100 shares per contract). Netting this intrinsic value loss against the initial $300 credit also results in a $200 loss. Therefore, $200 is the strategy’s maximum loss.

The two short options limit the investor’s gain potential. If MNO’s market price falls below $100, the short 105 put’s intrinsic value losses are offset by the long 100 put’s intrinsic value gains. If MNO’s market price rises above $110, the short 105 call’s intrinsic value losses are offset by the short 110 call’s intrinsic value gains. In either circumstance, the investor makes the maximum gain of $300.