Butterfly spreads are multi-leg option strategies that use four or more contracts. This chapter covers two related strategies:
A typical butterfly spread uses four contracts arranged in three strike prices (three unique legs). 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 $1ABC’s market price = $48
To establish this position, the investor pays a $4 net debit ($400 total). Here’s how the position behaves at expiration under three price outcomes.
If ABC’s market price falls to $40 or below
At $40, the long 40 call is at the money, and the other options are out of the money, so there’s no intrinsic value. If ABC falls below $40, all options are out of the money. In either case, the options expire worthless, and the investor loses the initial $400 debit.
If ABC’s market price rises to $50
At $50, the long 40 call is in the money by $10. The 50 calls are at the money, and the 60 call is out of the money, so those options have no intrinsic value at expiration.
This $600 is the strategy’s maximum gain.
If ABC’s market price rises to $60 or above
At $60:
The intrinsic value of the long 40 call ($20) is offset by the combined intrinsic value of the two short 50 calls (2 × $10 = $20). The 60 call has no intrinsic value at $60.
If ABC rises above $60, the position continues to offset: for each additional $1 increase in ABC, the long calls gain $1 of intrinsic value while the two short calls lose a total of $1 of intrinsic value. The investor is left with the initial $400 debit as the net result, which is the strategy’s maximum loss.
*Remember, intrinsic value represents gain for long contracts and loss for short contracts.
The strategy’s sentiment
This structure profits most when ABC finishes near the middle strike ($50). The maximum gain ($600) occurs at $50, and the further ABC moves away from $50, the more the payoff declines. Losses are limited to the initial $400 debit, so this version of a butterfly spread has a neutral (flat) market outlook with limited risk and limited reward.
Let’s look at another butterfly spread with a different market outlook:
Short 1 XYZ Mar 30 put at $1
Long 2 XYZ Mar 35 puts at $3
Short 1 XYZ Mar 40 put at $8XYZ’s market price = $34
To establish this position, the investor receives a $3 net credit ($300 total). Here’s how it behaves at expiration.
If XYZ’s market price falls to $30 or below
At $30:
The intrinsic value of the short 40 put ($10) is offset by the combined intrinsic value of the two long 35 puts (2 × $5 = $10). The 30 put has no intrinsic value at $30.
If XYZ falls below $30, the position continues to offset: for each $1 drop in XYZ, the two long puts gain a total of $1 of intrinsic value while the two short puts lose a total of $1 of intrinsic value. The investor keeps the initial $300 credit, which is the strategy’s maximum gain.
If XYZ’s market price rises to $35
At $35, the short 40 put is in the money by $5. The 35 puts are at the money, and the 30 put is out of the money, so those options have no intrinsic value.
This $200 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 puts are out of the money. If XYZ rises above $40, all options are out of the money. In either case, the options expire worthless and the investor keeps the initial $300 credit as the net gain.
The strategy’s sentiment
This version is designed to benefit from a larger move away from the middle strike ($35). The maximum gain occurs if XYZ finishes at or below $30, or at or above $40. The closer XYZ finishes to $35, the more likely the investor experiences a loss. Losses are limited to $200, so this butterfly spread reflects a volatile outlook with limited risk and limited reward.
An iron butterfly spread is similar to a straddle, but it adds “wings” to either reduce cost (for a long position) or limit risk (for a short position). There are two types:
A long iron butterfly spread is similar to a long straddle strategy, but it adds two out-of-the-money short options to reduce the cost of entering the position. 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 $1BCD’s market price = $70
A long straddle is a long call and a long put with the same strike price and expiration. If you isolate the two $70 options, you have a long straddle that costs an $800 total debit.
By also selling the 60 put and the 80 call, the investor collects $200 in premium, reducing the net cost of the long iron butterfly to a $600 debit.
Maximum gain
Like a long straddle, this position is built for volatility. The best-case outcome is that BCD finishes at one of the wing strikes ($60 or $80).
So, $400 is the strategy’s maximum gain.
The short “wing” options cap the upside. Below $60, gains on the long 70 put are offset by losses on the short 60 put. Above $80, gains on the long 70 call are offset by losses on the short 80 call. In either case, the profit stays capped at $400.
Breakeven
To break even, the investor needs intrinsic value equal to the $600 net debit. Because the position can profit from a move up or down, there are two breakeven points:
At $64, the long 70 put has $6 of intrinsic value ($600). At $76, the long 70 call has $6 of intrinsic value ($600). Either outcome offsets the $600 debit.
Maximum loss
This position loses when the market stays near the middle strike. If BCD finishes at $70, all options expire with no intrinsic value, and the investor loses the $600 net debit. That $600 is the maximum loss.
A short iron butterfly spread is similar to a long straddle strategy, but it adds two out-of-the-money long options to limit 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 $1MNO’s market price = $104
A short straddle is a short call and a short put with the same strike price and expiration. If you isolate the two $105 options, you have a short straddle that brings in a $600 total credit.
Buying the 100 put and the 110 call costs $300 in premium, reducing the net credit of the short iron butterfly to $300.
Maximum gain
Like a short straddle, this position benefits when the market stays near the middle strike. If MNO finishes at $105, all options expire with no intrinsic value, and the investor keeps the $300 net credit. That $300 is the maximum gain.
Breakeven
The investor breaks even when losses equal the $300 net credit. Because losses can occur on either side, there are two breakeven points:
At $102, the short 105 put has $3 of intrinsic value, creating a $300 loss ($3 × 100). At $108, the short 105 call has $3 of intrinsic value, also creating a $300 loss. Either outcome offsets the $300 credit.
Maximum loss
This position loses when volatility pushes the stock to (or beyond) the wing strikes. The worst-case outcomes are at or below $100, or at or above $110.
So, $200 is the strategy’s maximum loss.
The long “wing” options cap the downside. Below $100, losses on the short 105 put are offset by gains on the long 100 put. Above $110, losses on the short 105 call are offset by gains on the long 110 call.
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