Butterfly Spread

Definition

A butterfly spread is an options strategy that combines bull spreads and bear spreads with fixed risk and limited profit. These spreads are designed as a market-neutral strategy, achieving maximum profit if the underlying asset does not change before the options expire. They involve four call options, four put options, or a combination of call and put options with three strike prices.

Origin

The butterfly spread strategy originated with the development of the options market, particularly in the late 20th century, as options trading became more popular and investors sought more complex strategies to manage risk and return. The strategy's name comes from its graph shape, which resembles a butterfly's wings.

Categories and Features

Butterfly spreads are mainly divided into two types: call butterfly spreads and put butterfly spreads. Call butterfly spreads involve buying and selling call options with different strike prices, while put butterfly spreads involve put options. Their features include limited risk and profit, making them suitable for environments with low market volatility.

Case Studies

Case 1: Suppose an investor uses a butterfly spread strategy on XYZ company stock, buying two call options with a strike price of 50, and selling one call option each with strike prices of 45 and 55. If XYZ stock is priced at 50 at expiration, the investor will achieve maximum profit. Case 2: On ABC company stock, an investor uses a put butterfly spread, buying two put options with a strike price of 30, and selling one put option each with strike prices of 25 and 35. If ABC stock is priced at 30 at expiration, the investor will realize maximum gain.

Common Issues

Common issues investors face when using butterfly spreads include misjudging market volatility and the complexity of options pricing. Misunderstandings can lead to the strategy not being as profitable as expected. Additionally, transaction costs and liquidity are factors that need consideration.