How to position at the end of the volatility period? A volatility strategy that allows zero-cost position building and two-way profit—Short Butterfly Spread (Episode 22)

Have you ever encountered these trading dilemmas:

Expecting significant volatility but find the cost of buying a Straddle too high?

Anticipating a stock breakout but unsure of the direction?

Missed the low entry point and now stuck in a sideways market with no clear strategy?

The Short Butterfly Spread introduced in this article is precisely tailored for these scenarios. It achieves negative cost (cash flow at inception), two-way profitability (profit from both rises and falls), and high flexibility (adjustable by leg removal before expiration).

Short Butterfly Spread - Betting on Small Price Fluctuations

Strategy Composition:

Involves trading three types of options simultaneously:

Sell 1 lower strike (X1) Call, receiving premium (C1)

Sell 1 higher strike (X3) Call, receiving premium (C3)

Buy 2 middle strike (X2) Calls, paying premium 2*C2

Strike relationship: X2 = (X1 + X3)/2  

i.e., the strike of the bought options is the average of the two sold options

Initial premium net income = C1 + C3 - 2*C2

Note the trade ratio: Call1(sell) : Call3(sell): Call2(buy) = 1: 1: 2

All options have the same expiration

This strategy can also be built with Puts, with identical logic. The two approaches are very similar in both payoff and risk. 

Investment Rationale:

The core is betting on small price fluctuations of the underlying asset before option expiration.

Essentially, it combines bull spread and bear spread strategies:

Sell low strike Call1 + Buy middle strike Call2 = Bear Call Spread

Sell high strike Call3 + Buy middle strike Call2 = Bull Call Spread Thus combined becomes a neutral strategy: indifferent to stock direction, profiting from movement in either direction

Strategy Expiration P&L Diagram and Calculation Formula:

The red line represents the strategy payoff of Short Butterfly Spread

Net credit received = C1 + C3 - 2*C2

Lower breakeven stock price = X1 + net credit per share 

Upper breakeven stock price = X3 - net credit per share 

Profit when stock price < lower breakeven OR > upper breakeven

Maximum loss occurs when stock price = middle strike X2

Max loss = (X2 - X1)*100 - net credit 

Maximum profit achieved when stock price < X1 OR > X3

Max profit = net credit received

Strategy Characteristics

1. Neutral strategy with low reward/risk ratio but high win rate (see case study later).Profitable whether the stock "surges" or "plummets" beyond X1 or X3 - a long volatility play.

2. Deploy when the market is at the end of consolidation, about to choose direction (unknown up/down). That is, when volatility is low and expected to rise subsequently. This makes option prices rise, increasing your spread's profit.

3. High cost efficiency: Selling options offsets buying costs, enabling negative-cost entry.

Beta Practical Application

Disclaimer: The following is for illustrative purposes only, not investment advice. Users should refer to Beta's actual interface.

Assume a stock trades at $315/share. Xiao Li expects a breakout within ~3 weeks but is unsure of direction.

Execution:

Sell 1x 315 strike Call1

Sell 1x 325 strike Call3

Buy 2x 320 strike Call2

Net credit = C1 + C3 - 2*C2 = 1090 + 665 - 2*845 = $65

$65 is also the max profit, achieved when price <= 315 or >= 325

Lower breakeven = X1 + net credit/share = 315 + 65/100 = 315.65

Upper breakeven = X3 - net credit/share = 325 - 65/100 = 324.35

Profit when price < 315.65 OR > 324.35 (Note: theoretical, excluding transaction costs)

Max loss occurs if price expires at middle strike 320,

Max loss = (X2 - X1)*100 - net credit = (320 - 315)*100 - 65 = $435

Scenario 1: Price crashes to $250

Sold Call1 & Call3 expire worthless, premium kept = 1090 + 665 = $1755

Bought Call2 also expire worthless, premium paid = 2*845 = $1690

Total profit = 1755 - 1690 = $65 (max profit achieved)

Scenario 2: Price at $316, slightly above lower breakeven 315.65 (small loss)

Sold Call1 P&L = -(316 - 315)*100 + 1090 = $990 (profit)

Bought 2x Call2 & sold 1x Call3 expire worthless, net premium = 665 - 2*845 = -$1025 (loss)

Total P&L = 990 - 1025 = -$35 (loss)

Scenario 3: Price at $320 (max loss at middle strike)

Sold Call1 P&L = -(320 - 315)*100 + 1090 = $590 (profit)

Bought 2x Call2 & sold 1x Call3 expire worthless, net premium = 665 - 2*845 = -$1025 (loss)

Total P&L = 590 - 1025 = -$435 (max loss)

Though the reward/risk ratio appears low (65/435 = 0.15), profit triggers with just ±1.6% price movement beyond strikes, making win rate favorable in proper conditions (end of range, pre-catalyst).

Below charts show strategy payoffs at different prices: 

Usage Suggestions (Reference Only)

1. Generally prefer 30-45 DTE options to balance:

Sufficient time for price movement: Too short (<21 days) may not allow volatility to materialize

Avoid excessive theta decay: Too long (>60 days) accumulates theta loss, eroding long option value2. Deploy in low IV environment + expected catalyst scenarios like earnings, policy decisions when IV is historically low; set expiration 1-2 weeks post-event to capture IV expansion. Avoid entering too close to event when IV may already be elevated (see chart):

3. Center strike should be near current price (ATM), with 3-5% spacing between short strikes. Prioritize liquid US options to avoid unwinding difficulties. Note assignment risk on short calls (requiring stock purchase if unhedged) - close naked shorts pre-expiration if avoiding exercise. We'll introduce more option strategies later. Follow [Beta Investment Institute] for exclusive tutorials + market insights. Experience options trading via Beta App! For prior content, see "Options Trading Introduction" section below. Risk Disclosure: Options involve high risk of total loss. Investors with adequate experience, objectives, and financial capacity should carefully evaluate suitability.