A Handy Guide to Butterfly Spread Options Trading Strategies

In this article, we will discuss

• What are Butterfly Spreads?
• Setting Up a Butterfly Spread
• Different Types of Butterfly Spreads
• Find the Right Butterfly Spread for Your Trades with Options B.R.O. from Samco Securities

F&O traders in the options segment of the derivatives market have over 1,000 trading strategies to choose from. These strategies differ greatly from one another in terms of their complexity, risk levels, benefits, suitability and use cases. Among the comprehensive range of strategies available to choose from, butterfly spreads stand out for many reasons. 

They are versatile, easy enough to understand (even for beginners) and can be modified to suit different market conditions. In this article, we explore the different types of butterfly options strategies, how to implement them and when they can be used.

What are Butterfly Spreads?

Butterfly spreads are multi-legged options trading strategies that involve the use of four options contracts at three different strike prices. The options used can all be put options, call options or a combination of the two types. Depending on the nature of the options used, there are different types of butterfly options strategies.

All of these strategies are non-directional — meaning that they are not specifically suited to a bullish or a bearish market outlook. However, some of them are more effective when you expect high non-directional volatility in the underlying asset’s price, while others are better suited to markets where the asset’s price is expected to be relatively stable.

Butterfly options strategies or butterfly spreads are constructed in such a way that the risk involved is limited for the trader. Simultaneously, however, the profits are also capped. This limited risk and reward profile makes butterfly options strategies ideal for conservative or moderate risk takers.

Setting Up a Butterfly Spread

While the exact nature of the trades to be implemented depends on the type of butterfly options strategy you want to execute, here are the general steps involved in a butterfly spread:

• Step 1: Choose the Underlying Asset

Start by identifying the underlying asset whose price movement (or lack thereof) you want to capture in your trade. You may expect high or low volatility from this asset, but the direction of this move should be uncertain. Butterfly spreads are not as effective in directional or trending markets.

• Step 2: Select the Types of Options to be Used

Next, you need to select the types of options used. This will depend on the type of butterfly options strategy you plan to implement. For instance, in long or short call butterfly spreads, you use four call options. In long or short put butterfly spreads, you use four put options instead. Then, in iron butterfly spreads, you use a combination of put and call options.

• Step 3: Select the Strike Prices

All butterfly spreads use three different strike prices. One of the four options in the spread is at a lower strike price (that is below the asset’s current market price). Two of the options are at the middle strike price (that is the same as or very near to the underlying asset’s current price). The fourth option has a higher strike price (above the asset’s market price). Furthermore, the lower and higher strike prices should be equidistant from the middle strike price.

• Step 4: Choose the Expiration Date

For any type of butterfly options strategy to be effective, all four options chosen should have the same expiration date. Depending on the asset you are trading in, you can choose a near-month, next-month or far-month expiry. The expiry chosen should align with the timeline over which you expect the volatility or stability to materialise in the underlying asset’s market.

• Step 5: Execute the Strategy

Once you have assessed all the required parameters and made the selection as outlined above, all you need to do is implement the four-legged butterfly spread that you choose. Since you need to execute four traders simultaneously, manual processes may cause delays or errors. Fortunately, if you are a Samco Securities customer, you can use Options B.R.O. in the Samco trading app to execute your trade with just one click and capitalise on the market opportunity before it passes.

Different Types of Butterfly Spreads

Check out the different types of butterfly options strategies that you can implement using four call and/or put options at three different strike prices:

• Long Call Butterfly Spread

To implement this butterfly spread, you purchase an ITM call, sell two ATM calls and purchase an OTM call.

• Initial Position: Net debit
• Suitability: If you expect minimal volatility in the asset’s price at expiry
• Maximum Profit: If the underlying asset’s price equals the middle strike price at expiry
• Maximum Loss: Initial net debit of the premiums paid

• Long Put Butterfly Spread

To implement this butterfly options strategy, you purchase an OTM put with a lower strike price, sell two ATM puts and purchase another ITM put with a higher strike price.

• Initial Position: Net debit
• Suitability: When you expect low volatility at expiry
• Maximum Profit: If the asset closes at or near the middle strike price at expiry
• Maximum Loss: The net debit of the premiums paid

• Short Call Butterfly Spread

In this butterfly options strategy, you sell an ITM call option, buy two ATM calls and then sell another OTM call option.

• Initial Position: Net credit
• Suitability: If the IV is low but you expect the asset’s price volatility to increase by expiry
• Maximum Profit: If the asset closes above the upper strike or below the lower strike at expiry
• Maximum Loss: If the asset closes at or near the middle strike price at expiry

• Short Put Butterfly Spread

To implement this butterfly options strategy, you must sell an OTM put with a lower strike price, purchase two ATM puts and then sell another ITM put.

• Initial Position: Net credit
• Suitability: When you expect high volatility in the underlying asset by expiry but are not sure of the direction of the price movement
• Maximum Profit: When the asset price at expiry is above the higher strike or below the lower strike
• Maximum Loss: When the asset price at expiry is at or near the middle strike price

• Iron Butterfly Spread

In this butterfly options strategy, you use a mix of call and put options. To set up this four-legged trade, you should purchase an OTM put option at a lower strike price, sell an ATM put option and an ATM call option at the same strike price as the asset and finally, purchase an OTM call option with a higher strike price.

• Initial Position: Net credit
• Suitability: Low volatility scenarios in the underlying asset at expiry
• Maximum Profit: If the asset closes at the middle strike price at expiry
• Maximum Loss: If the asset closes above the upper strike or below the lower strike

Find the Right Butterfly Spread for Your Trades with Options B.R.O. from Samco Securities

As you may have gathered from this guide, different types of butterfly spreads are suitable for different market conditions. Finding and implementing the right butterfly options strategy may become challenging, especially in a dynamic market environment. To help trades overcome this hurdle, Samco Securities Limited has introduced Options B.R.O, an advanced options strategy builder, in the Samco trading app.

With Options B.R.O. from Samco Securities Limited, you can simply enter details about the options contract you want to trade in, its expiry and your market view. Based on this data, the options strategy builder from Samco Securities shows the top 3 strategies for you — one each with conservative, moderate and aggressive risk levels.

Depending on the market view you have, you may find butterfly options strategies among the shortlisted recommendations offered by Options B.R.O. from Samco Securities. Furthermore, you can also research, optimise and analyse these strategies to find the price points at which they deliver the maximum profit or loss.

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