Construction: The Short Butterfly spread is on the opposite side of the trade of the Long Butterfly spread. Therefore, the long and short options are exactly opposite of the long butterfly. The Short Butterfly trader therefore sells one call, buys two at a higher strike, and sells one at yet an even higher strike. A long Iron Butterfly produces the same profit and loss chart, but is established for a debit, and can be viewed as a Long Straddle with a short strangle around it.
Function: Limited directional stock movement play. Also, it can be a long volatility play. Bias – limited directional, regardless of the stock’s direction.
When to Use: When you feel the stock will trade away from a strike but not aggressively. Also if you feel the stock has a likelihood of an increase in implied volatility. The Short Butterfly allows you to take advantage of these potential situations while offering the investor a hedged position.
Breakeven: The Short Butterfly shares the same two breakeven points as the Long Butterfly. The lower breakeven is found by adding the credit to the lowest strike. The upper breakeven is found by subtracting the credit from the highest strike price.
Maximum Gain: Gains are made for all stock prices above the upper breakeven and below the lower breakeven. The maximum gain is the credit received and occurs if the stock closes above the highest strike, or below the lowest strike. The trade will also be profitable in event of increasing implied volatility.
Maximum Loss: Losses are realized when the stock closes between the breakeven points. The maximum loss is the credit received minus the difference in the long and short strike.
Key Concepts: The strategy can be broken down and viewed as two trades: With traditional butterflies (using all calls or all puts), the position can be broken down into two opposing vertical spreads, one long, and one short with each sharing the same short strike and different but equidistant long strikes. The Iron Butterfly can be broken down to a Long Straddle surrounded by a short strangle. Short Butterflies are best used with longer-dated options.
Example: Sell one $45 call, buy 2 $50 calls, sell one $55 call for a net credit of $2. The lower breakeven point is found by adding the $2 credit to the lowest $45 strike, which equals $47. The upper breakeven point is found by subtracting the $2 credit from the $55 highest strike, which equals $53. If the stock price closes between $47 and $53 at expiration, some losses will be incurred. The maximum loss is $3 and occurs if the stock closes at exactly the $50 center strike at expiration. If the stock closes outside of the breakeven points (below $47 or above $53) gains are made. The maximum gain is the $2 credit, which is realized if the stock closes below $45 or above $55.