Construction: The strategy can be constructed using all calls or all puts with the same expiration date. If using calls, buy one call, sell two calls at a higher strike, and buy one call at an even higher strike. All call strikes are usually equally spaced, but other constructions can be used. All calls must have the same expiration date. The standard butterfly using all calls (or all puts) always results in a debit. Another version called the Iron Butterfly is constructed using both calls and puts: Short a straddle while long a strangle around it. The Iron Butterfly results in a credit. All butterfly spreads, whether initiated for debits or credits, have limited gains and limited losses.
Function: Premium collection strategy with upside and downside protection. Also can be used as a short volatility play.
When to Use: When you feel the stock will trade in a very tight range near a strike price. Also, if you feel the stock has a likelihood of a decrease in implied volatility. The butterfly allows you to take advantage of these potential situations while offering the investor a hedged position.
Breakeven: The strategy has two breakeven points. The lower breakeven point is found by adding the debit to the lowest strike call. The upper breakeven is found by subtracting the debit from the highest strike call.
Max Gain: Gains are realized for all stock prices between the breakeven points. The maximum gain is found by subtracting the debit from the difference between one of the long and short strikes. The maximum gain is realized only if the stock price closes at exactly the short strike at expiration.
Max Loss: Losses occur for all stock prices outside of the breakeven points. The maximum loss is limited to the debit and occurs if the stock closes above the highest strike or below the lowest strike.
Key Concepts: The Long Butterfly is an ideal strategy for premium collectors who seek to limit potential losses in the event the stock moves adversely. This strategy can also take advantage of expected decreases in implied volatility. The strategy can be viewed as two separate trades: In the case of a traditional butterfly, the position can be broken down into two vertical spreads, one long and one short with each sharing the same short strike, and having different but equidistant long strikes. In the case of the Iron Butterfly, the position can be broken down to a Short Straddle surrounded by a Long Strangle. Butterflies are best entered into with longer dated options.
Example: Buy one $45 call, sell 2 $50 calls, buy one $55 call for a net debit of $2. The lower breakeven point is found by taking the lower $45 strike and adding it to the $2 debit, or $47. The upper breakeven is found by subtracting the $2 debit from the upper $55 strike, or $53. If the stock price closes between $47 and $53 at expiration, some gain will be made. The maximum gain is $3 and occurs if the stock closes at exactly $50 at expiration. If the stock closes outside of the breakeven points (below $47 or above $53) losses are incurred. The maximum loss is the $2 debit, which is realized if the stock closes below $45 or above $55.