Butterfly Option Strategy - Definition, Types & How to Use It?

Traders can create an option contract to buy or sell the underlying asset at a predetermined strike price. On the expiration date, the traders can exercise the option or ignore it (making the contract expire worthless). Investors commonly use the butterfly option strategy to benefit from neutral market conditions. It is a fairly complex strategy that minimises potential losses and results in good Returns. Let's understand the butterfly strategy and its types. 

What is the Butterfly Options Trading Strategy?

The options trading strategies aim to minimise the loss and increase the potential returns. The butterfly options strategy dictates the creation of four option contracts corresponding to the price movements. The expiration date of all the contracts is the same. Three prices are involved in the butterfly strategy. The options chain includes two call options and two put options. 

This non-directional strategy aims for good profitability when future volatility is expected to be higher or lower than the present implicit volatility. This is useful for creating bear spread and bull spreads with limited risk and a cap on the profit. Thus, it is efficient to offer maximum payoff if the asset doesn't make expected movements before expiration. 

Butterfly Option Trading Strategy – Explained 

The highlight of the butterfly options strategy is creating four options contracts with the same expiry date at three different strike price points. It creates a stable range of prices to help investors increase their profits. The contracts on the same underlying asset must be made as follows:

• Buy one call option at a higher strike price
• Buy one call option at a lower strike price
• Sell two call options at a middle strike price(the difference between high and low strike prices)

Ideally, the butterfly strategy works in a non-directional market when the expected security prices are not volatile in the future. So, traders can earn limited profits by taking a restricted risk. Investors can expect the best outcome when the contract nears its expiry, and the underlying asset's price equals the middle strike price. 

Types of Butterfly Option Strategy

Depending on the market conditions and how the contracts are deployed, there are different types of butterfly strategies. They are explained below:

Long  Call Butterfly Spread

It involves creating options contracts in the following ways:

• Buy one call option at a higher strike price
• Buy one call option at a lower strike price
• Sell two call options with a middle strike price. 

Here, maximum profit can be achieved when the spot price of the underlying asset on the expiration date matches the middle strike price of the two call options. The loss is limited to the premium paid for the options contracts.

Long Put Butterfly Spread

This strategy is used as below:

• Buy one put option at a higher strike price
• Buy one put option at a lower strike price
• Sell two put options at the middle strike price

This strategy is similar to the long call strategy but uses the put options. It helps limit the premium collected for the option, starting with a debt situation and making room for profits.

Short Call Butterfly Spread

A short-call butterfly spread is the opposite of a long-call butterfly. It involves:

• Sell one call option at a higher strike price.
• Sell one call option at a lower strike price.
• Buy two call options at a middle strike price, equidistant from the other two.

This strategy is used when the trader expects limited price movement in the underlying asset. Maximum profit is limited to the net premium received from selling the options. Maximum loss occurs if the underlying asset's price moves significantly beyond the outer strike prices.

Short Put Butterfly Spread

A short put butterfly spread is the put equivalent of the short call butterfly. It involves:

• Sell one put option at a higher strike price.
• Sell one put option at a lower strike price.
• Buy two put options at a middle strike price, equidistant from the other two.

This strategy is also used when expecting limited price movement. Maximum profit is limited to the net premium received from selling the options. Maximum loss occurs if the underlying asset's price moves significantly beyond the outer strike prices.

Iron Butterfly Options Strategy

An iron butterfly combines a short strangle and a long straddle. It involves:

• Sell one call option at a certain strike price.
• Sell one put option at the same strike price.
• Buy one call option at a higher strike price.
• Buy one put option at a lower strike price.

This strategy is used when expecting limited price movement. It has a limited profit potential and limited loss potential.

Reverse Iron Butterfly Spread

A reverse iron butterfly is the opposite of an iron butterfly. It involves:

• Buy one call option at a certain strike price.
• Buy one put option at the same strike price.
• Sell one call option at a higher strike price.
• Sell one put option at a lower strike price.

This strategy is used when expecting significant price movement in either direction. It has unlimited profit potential but also unlimited loss potential.

Conclusion

The butterfly option strategy combines different contracts to reduce losses and increase profit potential. You can limit the losses and maximise profit when different call and put options are used with the same expiration date and strike prices. Experienced options traders use such strategies with a detailed understanding of the effect of the call-and-put option. Learning and applying these trading strategies in the right market conditions is crucial to invest in the derivatives market successfully.