Long Butterfly Spread

The Long Butterfly Spread is a sophisticated options trading strategy used by experienced traders to benefit from low volatility and the stability of an underlying asset’s price. The strategy aims to achieve a profit by correctly predicting that the price of the underlying asset will remain close to a specific target price at expiration. This method is particularly useful in scenarios where the trader anticipates minimal movement in the underlying asset.

Structure of a Long Butterfly Spread

A Long Butterfly Spread involves three different strike prices and uses a combination of both calls or both puts. The structure comprises:

  1. Buying one lower strike option (long position)
  2. Selling two middle strike options (short position)
  3. Buying one higher strike option (long position)

This forms a “butterfly” shape in terms of the profit/loss diagram, with the maximum profit achieved at the middle strike price and bounded risk defined by the outer strike prices.

Call Option Butterfly

Assume we have an underlying asset currently priced at $100. To create a Call Long Butterfly Spread, a trader could:

Put Option Butterfly

Alternatively, with the same underlying asset priced at $100, a trader could also set up a Put Long Butterfly Spread:

Profit and Loss Potential

The maximum profit, maximum loss, and breakeven points can be predetermined, which makes the butterfly spread an attractive strategy for traders seeking defined outcomes.

Maximum Profit

The maximum profit is achieved if the underlying asset’s price is exactly at the middle strike price at expiration. This can be calculated as follows:

[ \text{Max Profit} = \text{Middle Strike Price} - \text{Lower Strike Price} - \text{Net Premium Paid} ]

Maximum Loss

The maximum loss occurs if the underlying asset’s price is either below the lower strike price or above the higher strike price at expiration. This is limited to the net premium paid for the strategy.

[ \text{Max Loss} = \text{Net Premium Paid} ]

Breakeven Points

There are two breakeven points for a Long Butterfly Spread:

  1. Lower Breakeven Point: [ \text{Lower Strike Price} + \text{Net Premium Paid} ]

  2. Higher Breakeven Point: [ \text{Higher Strike Price} - \text{Net Premium Paid} ]

Advantages of Long Butterfly Spread

  1. Limited Risk: The potential loss is limited to the net premium paid.
  2. Defined Profit: The maximum profit, although limited, is clearly defined.
  3. Neutral to Low Volatility: Suitable for markets expected to have low volatility.

Disadvantages of Long Butterfly Spread

  1. Limited Profit Range: The strategy offers limited profit potential compared to other strategies.
  2. Commissions: Multiple legs in the strategy may result in higher transaction costs.
  3. Complexity: The structure is more complex than simple option strategies, requiring more expertise and management.

Organizations and Platforms Supporting Butterfly Spreads

Several platforms and brokers provide the tools and education necessary for implementing Long Butterfly Spreads, including:

Conclusion

The Long Butterfly Spread strategy is an advanced options trading method designed for scenarios of low volatility and stable underlying asset prices. By carefully structuring the spread and understanding the profit/loss dynamics, traders can efficiently use this strategy to capitalize on predicted market conditions while keeping risks manageable and predefined.