A butterfly is an option spread position involving two vertical spreads, one long and one short, in which the short strike is common.
The butterfly spread therefore involves three equidistant strikes. For a long butterfly, a net debit is paid. In this strategy, the trader is long one contract at a lower strike (wing), short two contracts at a middle strike (the body), and long one contract at an upper strike (wing), each with the same expiration. The size may be increased, although the same 1-2-1 relationship remains the same where the “body” is 2x the size of each “wing” (ex: 2-4-2, 3-6-3, 4-8-4, etc.).
Butterflies can be done using calls or puts, and can be constructed as either a bullish, bearish, or neutral position.
A neutral butterfly would use an ATM short strike, expecting price to stay at or near current levels by expiration. The neutral butterfly is therefore fully dependent upon theta decay of the short options.
A bullish butterfly would use an OTM call as the short strike. This way, an increase in the share price would bring it closer to the short strike, which is where max gain would be seen at expiration.
A bearish butterfly would use an OTM put as the short strike. With this position, a decrease in the share price would bring it closer to the short strike where the max gain would be seen at expiration.
Construction of a Butterfly Spread
A butterfly spread is a long vertical spread overlapping the short strike with a short vertical spread. In the case of a bullish call butterfly, the individual trade components are:
Long 1 $50 call (long component of a long call vertical)
Short 1 $55 call (short component of a long call vertical)
Short 1 $55 call (short component of a short call vertical)
Long 1 $60 call (long component of a short call vertical)
Because the short strikes overlap from each vertical spread, the net butterfly position is:
Long 1 $50 call (wing)
Short 2 $55 calls (body)
Long 1 $60 call (wing)
Butterfly spreads are low-probability, high-reward positions. This means the probability of success is low, but they can produce big profits when they work. The probability of success for a butterfly is calculated by dividing the debit paid by the width of the strikes.
For example, take a $50/$55/$60 call butterfly done for a debit of $0.60. To determine the probability of the trade, we take the $0.60 debit divided by the $5 strike width ($0.60 / $5.00 = .12), which gives the trade a 12% probability of success.
The max gain for a butterfly is the difference between one wing strike and the body strike (upper vertical spread or lower vertical spread) less the debit paid. Using the same $50/$55/$60 example, it’s a $5 wide butterfly which cost $0.60, which would create a max gain of $4.40 ($5 – $0.60 = $4.40). It’s often sensible to close out a butterfly position when either the directional bias for the trade has changed, or when most of the profit has been made with little time remaining until expiration.
Because butterflies are so dependent upon theta decay of the short options, they become much more sensitive to movement as expiration approaches. Some traders like to place butterflies at levels where they expect the stock to “pin” at expiration. Because they are low-probability trades, position size should be smaller.
Butterflies tend to be somewhat commission intensive due to the multiple legs of the position. Vega is highest at the money, so a long butterfly is generally considered a vega negative trade. This means that the trade will benefit from a contraction in IV, particularly when price is near the short strike, as contracting IV suggests a lower likelihood of price moving. When price is nearer to the outer strikes, it will benefit from an increase in IV (vega positive), as that improves the chances of price moving toward the short strike.
Return to the main trading glossary page to learn more terms.