Butterfly Strategy: Meaning & Options Trading Strategy

Financial trading involves multiple strategies, but the best is the one that is consistent, verifiable, and objective-driven, contributing to economic growth and complying with the market conditions. While some strategies work best with a volatile market, some don’t. The butterfly strategy is commonly used in options trading and aims at a higher profit margin without the stress of an unlimited loss. 

What Is a Butterfly Strategy Option? 

The butterfly option is a four-winged approach involving four option contracts (call option and put option) at three strike prices and one expiration date. It is market-neutral, non-directional and is best suited to a stable market. The best part, though, is that the loss is pre-defined.  

The key point is to decide the correct strike price. Typically, there can be three kinds of strike prices:

• When the strike is the same as the current stock price (ATM)
• When the strike is conducive to the current stock price (ITM)
• When the strike is not conducive to the current stock price (OTM)

In a butterfly option strategy, the aim is that the actual market price should not go beyond the range of the strike price. The more stable it is, the more your earnings will be. 

Types of Butterfly Option Strategy

Let’s look at the different types of butterfly option strategies:

• Long Call Butterfly Strategy: It is most suitable to a less price-changing market. The strike prices need to be in the nearest range of the market price. For example, assuming that the current stock price of a particular company is INR 50, purchase one call at INR 45 and another call at INR 55, followed by selling two call options at INR 50. 
• Short Call Butterfly Strategy: An absolute opposite to the long-call butterfly option, this strategy is best suited for a volatile market, where there is a high possibility of price changes. The higher the range, the better the profits. For example, assuming that the current stock price of a particular company is INR 50, sell one call option at INR 45 and another call at INR 55, following the purchase of two call options at INR 50. 
• Long Put Butterfly Strategy: This is similar to a long-call butterfly option, but in this case, the trading is done on put options. The returns are best if the actual stock price stays near the strike price. For example, assuming that the current stock price of a particular company is INR 50, purchase one put option at INR 45 and another put at INR 55, followed by selling two put options at INR 50. 
• Short Put Butterfly Strategy: This option trading strategy involves trading with put options. Similar to a short-call butterfly option, the returns are best when the actual stock price moves beyond the range of a strike price. For example, assuming that the current stock price of a particular company is INR 50, sell one put option at INR 45 and another one at INR 55, followed by purchasing two put options at INR 50.
• Iron Butterfly Option Strategy: The best part of this strategy is that the investor can trade both call and put options, limiting the gains and losses. Also, since the strike prices are supposed to be kept very close to the actual stock price, the best usage of this strategy is when the market is not volatile. For example, assuming that the current stock price of a particular company is INR 50, purchase one put option at INR 45 and another call option at INR 55, followed by selling one call option and one put option at INR 50.  

How To Set Up a Butterfly Option Strategy

The steps to set up a butterfly option strategy are as follows:

Step 1: Buy One Option

The trader, in this case, buys one at-the-money (ATM) call or put option. For these, the strike price is closest to the current price.

For example, the trader buys a call option with a strike price of ₹500 and an expiry date in one month.

Step 2: Sell Two Options

Here, the trader sells two out-of-the-money (OTM) options, where the strike price is either above or below the ATM option. 

Now, the trader sells two respective options at ₹550 and ₹600 with the expiry date in a month.

Step 3: Buy One Option

In this step, the trader buys an OTM option with a strike price that is quite higher than the current price of the underlying asset and also the value of the two options sold.

Here, the trader buys another call option for ₹650, which is to expire in one month.

When these trades are taken, there are three scenarios that may arise:

Scenario 1

If the price remains within the range, i.e., 500-600, it will be a gain for traders. The sold options become idle and expire, while the ones bought reap profit for the traders. The maximum profit is generated if the price settles at ₹600.

Scenario 2

If the price moves up from ₹600, the sold options turn in-the-money, and maximum losses occur. However, the traders can offset the losses using the profits earned from the purchased options, which limits the loss.

Scenario 3

If the price drops below ₹500, it leads to maximum loss. Here, even the purchased options lose their value.

Butterfly Option: Yes or No? 

To weigh the advantages and disadvantages of the strategy you implement, let’s look at some pros and cons of applying the butterfly option strategy. 

Advantages: 

• Defined loss with a high potential of profits vs. risk: Since the loss is defined by a number (net-debit), there is a higher possibility of making profits, provided the stock price moves according to the strategy applied. 
• Flexibility of Options: There are different ways you can choose to buy/sell the options contract based on your understanding of the market.  
• Suitability to less volatile markets: If the market stock price is relatively stable, using the butterfly option is the best way to maximise returns.  

Disadvantages: 

• Complex Execution: Since there are four options contracts involved, it can be difficult to execute this manually. Therefore, professional help is recommended.
• Sensitivity to market conditions: The entire principal is sensitive to the market conditions. If the market is volatile and you apply a neutral strategy, it will not yield good results.
• Cost Consuming: Yes, no matter which strategy you apply, you will need to have enough liquidity to execute the funds. 

Alternate Strategies: If Not Butterfly Option, Then What?

Here are some market-neutral alternative strategies in options trading:

• The Straddle Method: Buy/sell both call options and put options at the same strike price and expiration day. As long as the price moves from the strike, profit is indefinite.
• The Strangle Method: It’s an extension of the straddle strategy. The difference between the two is that the cost is lower in strangle. How? Unlike in straddle, here you will need to buy stocks in OTM call or put options, which are relatively cheaper.
• The Iron Condor Method: It’s a four-way method for investors to buy one of each option- long/short put option and long/short call option. However, in this case, the strike price can differ, but the expiration has to be constant. It provides flexibility, especially for less volatile markets. 

Conclusion

While financial trading does accelerate economic growth, it is important to consider all the correct options and do the right amount of research before investing. The butterfly option is suitable for investors looking at a risk-defined profitability approach. It is flexible and safe, but it also comes with a set of execution challenges, high costs and complexities. Market conditions play a key role in the profitability of your investment. 

Connect with Torus Digital to kick-start your investment journey, or to take the existing one to new heights!

FAQs

• How does a long butterfly spread work?

  It is a three-way contract where you buy/sell one option at a higher strike price and one at a lower strike price, and sell/buy two options at an even strike price.

  What is the difference between a butterfly spread and an iron butterfly?

  The key difference between a butterfly spread and an iron butterfly lies in the type of option used. A standard butterfly spread uses only calls or only puts (same type), whereas an iron butterfly uses a combination of puts (at the lower strikes) and calls (at the higher strikes), with the same middle strike for both options.

  When is the best time to use a butterfly spread?

  The best time to use a butterfly spread is when there is a zero or less possibility of the stock price changing. Dynamic changes in stock prices make the market volatile, which does not suit the butterfly option strategy.

  Can a butterfly spread result in unlimited loss?

  No. If you use a butterfly spread, the strike prices will have to be close to the actual market price. The net debit per stock is, therefore, defined before investing. However, should the actual market price go beyond the range of the strike price, the butterfly spread expires, and the maximum loss suffered is equal to the net debit invested.

  Is a butterfly spread good for beginners?

  No. Due to its complex structure, it is advisable to seek professional help to execute the process.

  What happens if the stock moves too much in a butterfly trade?

  If the stock price moves beyond the range of the pre-decided strike price, the butterfly spread expires, and the loss is then equal to the net debit invested.

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