Options traders employ butterfly spreads to their advantage. Make sure you understand the difference between options and futures contracts, which are both types of financial instruments. The underlying asset can be bought or sold via an option contract at a defined expiration date.
Meaning of Butterfly Spread Option Strategy
Traders who seek to balance gains with risks might use this neutral option strategy.
It’s a good idea to use long butterfly spreads when you don’t expect the underlying stock to move much before expiration. To get into the trade, a net debit must be taken.
Formula cum Construction of Butterfly Spread Option
Long Call Butterfly: An investment in the Long Call Butterfly can be considered neutral because of the little volatility that is likely to accompany the underlying price. In this case, we’re using a bull spread and a bear spread together. One ITM call, two ATM calls, and one OTM call must all be purchased. When writing options, the strike price should be identical to the current price.
- Take for example that the current price of the Nifty is 10600. It’s not going to be terribly volatile, as you’d expect. The Long Call Butterfly strategy can be executed by beginning with the purchase of one ITM call option at 10500, then selling two ATM – (Nifty call options) at 10600, and finally purchasing one OTM call option at 10700.
- Achieve equal-distance strike prices for all options. Your maximum loss will be equal to the sum of the net premiums that you have paid for the four positions, and your maximum profit will be equal to the strike price of the short calls.
- In times of high market volatility and uncertainty, traders often swap techniques to see if they can get a better return on their investment.
- A pure vanilla option with a strike of 1 can be either called or put, and it can be bought or sold. This type of trade is the most popular among traders. Investors in options often use four-leg strategy when volatility is high.
- Trading two-leg strategies such as Bull-Call Spread or Bear-Put Spread, which restrict losses and profits but sometimes don’t appear worth holding the position, is nearly impossible in today’s market, when the market has become extremely volatile with big intraday swings.
Choosing the Butterfly
When choosing the Butterfly, there are a number of considerations to take into account, such as the amount of time until the option expires, the trading range, and whether or not you anticipate the market to be heading sideways or upward.
There is less activity in the Butterfly than in vertical spreads or vanilla options when the period to expiration is longer.
If a trader wishes to cover a greater range, he will have to pay additional premiums. As the distance between Butterflies strikes widens, so does the price one must pay.
Strategy at Glance | Long Call Butterfly
When the stock price is expected to move near the spread’s centre strike price, the best strategy is to utilize a long butterfly spread with calls. This strategy takes advantage of time expiry. In contrast to short straddles or strangles, a lengthy butterfly spread’s potential risk is restricted.
- By comparison, the potential profit from short straddle or strangle is more than that of the long butterfly spread. Because of this, brokers who use butterfly spreads make more money.
- Changes in volatility can have a significant impact on long butterfly spreads. Volatility increases and decreases the net value of a butterfly spread. When traders predict low volatility, they buy butterfly spreads.
- Some traders acquire a butterfly spread just before an earnings release since volatility in option pricing tends to diminish substantially after these reports.
- The potential reward is substantial when expressed as a percentage, and the risk is confined to the expense of maintaining the position, which may include commissions.
- In order for this strategy for purchasing butterfly spreads to be successful, it is necessary for the stock price to remain inside the range defined by the butterfly’s lower and higher strikes. Stock price swings can result in a loss if they are excessive.
- Even when the expiration date approaches and the stock’s price approaches the centre strike price, the value of long butterfly spread with call options does not grow significantly, resulting in little return.
(If the stock price doesn’t shift out from the profit area, short overlaps and short restrains begin to show significant profit soon in the expiration cycle.)
- The butterfly spread can be executed with either puts or calls. A variety of butterfly spreads can be created by combining choices in various ways. Bull and bear call spreads are sometimes combined in long butterfly spreads. The long call with the lowest strike price and one of the short calls with the centre strike price are the components of the bull call spread. The long call with the highest strike price and the other short call with the centre strike price are the components of the bear call spread.
- We sincerely hope that you enjoyed reading this post. To fully grasp the meaning of this jargon-heavy terminology, you must be familiar with the stock market. Basically, this article is here to educate people. We don’t give or endorse any stock-related advice. Consult with professionals before making any financial investing decisions.