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2022年7月1日

What Is the Butterfly Spread Strategy?

In options trading, the butterfly spread strategy is a neutral approach that profits from movement in either direction in the market. It’s structured to combine both bull and bear spreads, and comes with controlled risks and profit.

By default, the butterfly spread has four positions (either four calls or puts) and three strike prices with the same expiration date: One is at-the-money (ATM), while the other two are below and above the ATM strike price, respectively. For example, if an ETH option has a $1,150 ATM strike price, the lower strike price would be $1,150 − $150 = $1,000, and the upper strike price would be $1,150 + $150 = $1,300.

Different types of butterfly spreads arise from different combinations of put and call options, which determine whether the spread profits from low — or just enough — volatility. 

There are different types of butterfly spreads. Some of the most common are:

  1. Long Call Butterfly Spread

  2. Short Call Butterfly Spread

  3. Long Put Butterfly Spread

  4. Short Put Butterfly Spread

  5. Iron Butterfly Spread

  6. Reverse Iron Butterfly Spread

The Long Call Butterfly Spread

long call butterfly spread

Image Source: The Options Playbook

The long call butterfly spread is achieved by combining four call options. You sell/write two ATM call options, buy one out-of-the-money (OTM) call option at a higher strike price, and buy one in-the-money (ITM) call option with a lower strike price. You receive a debit when entering the positions (i.e., you incur the total cost in premium paid).

The long call butterfly spread comes in handy when the bias is a ranging or stagnant market. When there’s low volatility, an investor expects the underlying asset not to move much — or even at all. Profit is recorded when the underlying asset retains the ATM strike price at the time of expiration. 

The Short Call Butterfly Spread 

short call butterfly spread

Image Source: The Options Guide

The short call butterfly spread is also a combination of four calls, but this time in a reversed manner. You buy two ATM call options, sell one ITM call option with a lower strike price, and sell one OTM call option. You receive credit when entering the positions. Essentially, you get paid to open the positions. 

The short call butterfly spread is activated when there’s a bias for notable price movement due to high volatility. Profit is recorded if the underlying asset 1) closes above the upper strike price at the time of expiration, or 2) closes below the lower strike price at the time of expiration.

The Long Put Butterfly Spread 

long put butterfly spread

Image Source: The Options Playbook

The opposite of the long call butterfly spread, the long put butterfly spread is a combination of four put options. You sell two ATM puts, and buy the other two at a lower and higher strike price, respectively. You also receive a debit when entering this position, and profit is recorded if the underlying asset remains ATM at the time of expiration.

The Short Put Butterfly Spread

short put butterfly spread

Image Source: The Options Guide

The short put butterfly spread is also the opposite of its twin, the short call. It involves buying two ATM puts, selling one ITM put at a higher strike price, and selling one OTM put at a lower strike price. Maximum profit is recorded if the underlying asset closes below the lower strike price, or above the higher strike price. 

Iron Butterfly Spread

iron butterfly spread

Image Source: The Options Playbook

Here’s how the iron butterfly spread is set up: 

  • Buying an OTM call option with a higher strike price

  • Selling an ATM call option

  • Selling an ATM put option

  • Buying an OTM put option with a lower strike price

The outcome of this combination is a trade that works well for low volatility. Maximum profit is recorded if the underlying asset remains at the middle strike price.

Reverse Iron Butterfly Spread

reverse iron butterfly spread

Image Source: The Options Guide

Here’s how the reverse iron butterfly spread is set up: 

  • Selling an OTM call option with a higher strike price

  • Buying an ATM call option

  • Buying an ATM put option

  • Selling an OTM put option at a lower strike price. 

This setup creates a debit that works best in highly volatile situations. Maximum profit is recorded when the underlying asset moves above the upper strike price, or below the lower strike price.

Butterfly Options Setup

For a long or short call butterfly spread:

  • Buy one ITM call 

  • Buy two ATM calls

  • Buy one OTM call

For a long or short put butterfly spread:

  • Buy one ITM put

  • Buy two ATM puts

  • Buy one OTM put

Butterfly Options Strategy

The butterfly options strategy combines a bull spread and a bear spread that converge at a middle strike price. The basic setup for a butterfly spread requires opening four positions:

  • Buying one OTM call above the current price of the underlying asset

  • Buying one ITM call below the current price

  • Selling two ATM calls at the current price (or very close to it) 

This strategy is designed to help a trader profit from movement in either direction in the market — or no movement at all. Depending on the combination of options (either call or put), the strategy can benefit from both low and high volatility.

Who Is the Butterfly Spread Strategy For?

Due to its complexity, the butterfly spread strategy is best suited to intermediate/expert traders and investors. While it has a capped profit and limited risk attribute, strong technical knowledge is required to properly wield the butterfly options strategy.

Before considering butterfly options, traders first need to fully grasp the “Greeks” (Gamma, Theta, Vega, Rho) and other contributing factors. Sound understanding of the Greeks cannot be overemphasized, because there will be times the market changes direction from initial prediction, and live adjustments will be needed for the strategy to avoid maximum losses.

When to Use the Butterfly Spread Strategy

The butterfly spread is an advanced strategy because of the controlled risk and profit it offers. The long butterfly strategy is activated when there's a neutral or mildly bullish bias. It’s dependent on the difference between the asset price and the middle strike price, when the position is set up.

In a scenario where the asset price is very close to the middle strike price (or exactly the same with it when the position is activated), an investor's bias would be neutral. Likewise, if the asset price is below the middle strike price at activation, the investor's bias would be mildly bullish (i.e., the asset price should rise to the middle strike price at the time of expiration).

Breakeven Point

The long call butterfly spread records profit when the asset remains at the middle strike price or ATM strike price at the point of expiration. For breakeven, there are two points, since there are two spreads. Here's how to calculate them:

Upper breakeven point: Higher strike price for a long call or put = Strike price minus the premium paid. 

Lower breakeven point: Lower strike price for a long call or put = Strike price plus the premium paid. 

Maximum Take Profit Potential

For a long call butterfly spread, the maximum profit potential is the difference between the middle strike price and the lower strike price minus the premium paid (cost of opening the position + commissions). Recall that maximum profit is only recorded when the asset price remains at the middle strike price or ATM at the point of expiration. 

Although not impossible, it’s unlikely that you’ll obtain maximum returns with the butterfly spread strategy. A good percentage to take profit in the long call butterfly is 20–50% of the maximum profit.

Maximum Incurred Loss Potential

One of the advantages of the butterfly spread strategy is its limited risk. Maximum loss potential is restricted to the total premium paid (i.e., the cost for opening the position + commissions). Loss can be incurred in two ways: If the asset price closes above the higher strike price or below the lower strike price at expiration, the other calls expire and the total premium paid is lost to the market.

Example

Let’s assume 1 ETH is currently trading at $1,150. If investors believe ETH will move slightly, or remain stagnant over the next couple of months, they’ll go for the long call butterfly spread to potentially profit from the stagnancy. The investor writes or sells two call options on ETH at a strike price of $1,150, and buys two other call options at $1,300 and $1,000.

In this assumption, the investor records maximum profit if ETH’s price remains at $1,150 at the time of expiration. If ETH closes above $1,300 or below $1,000, maximum loss is incurred. 

One important thing to additionally note is the premium paid. For example, if ETH closes between $1,300 and $1,150, a loss or profit could be recorded, depending on the premium paid. Let's take $50 as the premium paid to enter a trade. If the price closes between $1,200 and $1,100 (i.e., adding and subtracting the premium to both ends), the trade will record profit. Anything above or below these prices will incur a loss.

Trading Butterfly Options

Bybit offers multiple cryptocurrency options. To trade crypto options, visit the official Bybit website and click on Derivatives > USDC Options.

As seen in the below snapshot, you can view all available options on the exchange. To get started, click on the option of your choice (currently, only BTC options are available), fill in the quantity of crypto you want to purchase, and click on Place Order.

You can then see all the calls and put options along with their corresponding strike prices.

Click the call/put options you prefer, in order to enter the quantity of the crypto you want to trade, and then place your order.

Tips

Here are two tips to help you maximize profits from the butterfly spread strategy:

  • Analyze the market you’re trading in order to determine if it’s of low or high volatility (typically, crypto markets are of high volatility).

  • Always look out for a neutral or ranging market before choosing long call butterfly options.

Margin Requirements

All margin requirements for options in the U.S. are regulated by Federal Reserve Board Regulation T, also known as Reg T. For long butterfly calls, all the options contained in it must be the same in terms of the underlying asset, the interval between prices, and the expiration date.

Basically, the long butterfly call comprises two short positions (call or put) of the same components (strike price, class, expiration date) bordered by a long position of the same class (call or put) at a higher strike price, and one long position of the same class with a lower strike price.

Theta Decay Impact

Theta refers to how much time decay affects the total value of a position. For every asset, the total value reduces in relation to the proximity of the expiration date (i.e., the closer a position gets to its expiration date, the lower its value becomes).

Time decay (or Theta) works against the long call butterfly spread and favors the short call butterfly spread. This means a long call has a negative theta (loses money with time decay), whereas a short call has a positive Theta (makes money with time decay).

However, the case becomes different for the long call if the asset price ranges between the higher and lower strike prices, and Theta becomes positive. If it moves out of range, Theta becomes negative as the time to expiration draws closer.

Implied Volatility Effect

Since the actual volatility of an option can't be predicted before entering a position, the assumption or calculation of implied volatility became a consideration in options trading. Volatility shows how much an asset price fluctuates in terms of percentage. In options, as volatility increases, the price of an option rises with it when other factors are kept constant. Vega is the technical word that represents volatility.

Long options make money from an increase in volatility, while short options lose money when volatility increases. The reverse is the case when volatility reduces. 

For a long call butterfly spread, the long call rises (makes money) when volatility falls. When volatility increases, the long call falls (loses money). Therefore, the long call butterfly has a −Vega (negative Vega) and should only be bought when there's high volatility, with a bias for a subsequent decline.

Benefit

The butterfly spread options strategy has a better hedging strength against very large intraday volatility and large price movements than other options strategies.

Risks

Regardless of how protective a strategy is, there will always be risk involved. Here are some common risks associated with the butterfly spread strategy:

  • High cost to enter trades, plus commissions and taxes

  • OTM options expiring or delivering on the expiration date can work against the investor

  • Longer expiration dates in the market can change 

Conclusion

If what you seek as a trader is to profit from different market conditions and get paid constantly, then the butterfly options strategy could be your best bet. It offers a better hedge to market fluctuations and uncertainty. The only thing required is to apply this strategy with adequate understanding and discipline — so that outcomes can work in your favor.