Butterfly Spread
The term butterfly spread refers to an options strategy that combines bull and bear spreads with a fixed risk and capped profit. These spreads are intended as a market-neutral strategy and pay off the most if the underlying asset does not move prior to option expiration. They involve either four calls, four puts, or a combination of puts and calls with three strike prices.
Definition: A butterfly spread is an options strategy that combines bull spreads and bear spreads, featuring fixed risk and limited profit. These spreads are designed as a market-neutral strategy, achieving maximum profit if the underlying asset remains unchanged before the options expire. They involve four call options, four put options, or a combination of call and put options with three different strike prices.
Origin: The butterfly spread strategy originated in the early stages of options trading. As the options market developed and matured, traders discovered that combining different options could achieve more complex trading strategies. The butterfly spread strategy became widely used during the rapid development of the options market in the 1970s.
Categories and Characteristics: Butterfly spreads are mainly divided into two categories: call butterfly spreads and put butterfly spreads. A call butterfly spread involves buying one call option with a lower strike price, selling two call options with a middle strike price, and buying one call option with a higher strike price. A put butterfly spread involves buying one put option with a higher strike price, selling two put options with a middle strike price, and buying one put option with a lower strike price. Both types have limited risk and reward, making them suitable for markets with low volatility.
Specific Cases: Case 1: Suppose a stock is currently priced at $100. An investor can construct a call butterfly spread by buying one call option with a strike price of $95, selling two call options with a strike price of $100, and buying one call option with a strike price of $105. If the stock price remains around $100 at expiration, the investor will achieve maximum profit. Case 2: Suppose a stock is currently priced at $100. An investor can construct a put butterfly spread by buying one put option with a strike price of $105, selling two put options with a strike price of $100, and buying one put option with a strike price of $95. If the stock price remains around $100 at expiration, the investor will achieve maximum profit.
Common Questions: 1. What is the maximum risk of a butterfly spread? Answer: The maximum risk of a butterfly spread is that the underlying asset's price will fluctuate significantly at expiration, causing the strategy to fail. 2. What market environment is suitable for a butterfly spread? Answer: A butterfly spread is suitable for a market environment where the underlying asset's price is expected to remain relatively stable before the options expire.
