To protect your investment, you should introduce a vertical spread to create a 1 3 2 butterfly spread.
What Is the 1:3:2 Options Strategy?
One of the leading butterfly trading criticisms is that they don’t metamorphose until the price is near expiration. Therefore, we love butterfly spreads’ low risks and high rewards. But if you’re trading options, use the 1-3-2 butterfly spread instead of 1:2:1.
The 1:3:2 butterfly spread lowers the spread’s cost by purchasing the traditional butterfly spreads and the overlapping short vertical spreads. It’s designed to reduce losses in exchange for maximum profits. When it expires OTM (out-of-the-money), then you will lose your total capital investment.
Therefore, a 1:3:2 trade is a put or long call butterfly with the sale of put or call spread in the butterfly spread. The sale of a put or call vertical can be made when you want to receive a credit to pay for a butterfly spread.
When used correctly, the 1:3:2 trade has a high likelihood of leaving you in profit, most of the time.
For more details on the 1 3 2 butterfly spread and the butterfly spread formula. Please continue reading our Butterfly spread explained guide.
What is Butterfly Spread?
A butterfly spread is a unique options strategy that combines bear and bull spreads with capped profit and fixed risk. These spreads are a market-neutral strategy, but they pay more if the asset doesn’t move before option expiration.
A great Butterfly spread example includes 4 puts, 4 calls, or a combination of calls and puts with 3 strike pieces.
These spreads create a unique strategy that is used by options traders. Options are financial instruments based on the underlying asset’s value. These contracts allow traders to sell or buy assets by a specified expiration date.
This pattern merges a bear and bull spread. It’s a neutral strategy with 4 contracts with the same expiration date but 3 strike prices:
- Lower strike price
- At-the-money strike price
- Higher strike price
What are the types of butterfly spread options?
Short Call Butterfly Spread
You can create this spread by selling one ITM option with a low strike value, purchasing 2 ATM call options, and then selling an OTM call option at a high strike price. When entering this position, you’ll create a net credit.
Long Call Butterfly Spread
You can create this spread by purchasing 1 ITM call option with a lower strike price, writing 2 ATM call options, and purchasing 1 OTM call option with a high strike price. When you enter this trade, you create a net debt.
Long Put Butterfly Spread
You can create this spread by purchasing 1 put with a low strike price, selling 2 ATM puts, and buying 1 put with a higher strike price. It creates a net debt when you enter this position.
Short Put Butterfly Spread
You can create this spread by writing 1 OTM put option with a lower strike value, purchasing 2 ATM puts, and writing 1 ITM option at a high strike value.
What are the characteristics of a butterfly spread?
- A butterfly spread uses 4 options contracts with similar expiration dates but 3 strike prices. But this varies with the types of butterfly spreads.
- The lower and upper strike prices are the same distance from the ATM or middle strike price.
- A butterfly spread pays off the most when the underlying security doesn’t move before the options expire.
Example of a 1:3:2 Butterfly Spread
The IBM options closing put prices are 105 ($0.53), 110 ($0.79), 115 ($1.26), 120 ($2.16), and 125 ($3.88).
Its price is $125, while the regular butterfly spread options example, 125-120-115 put, will cost $0.82 per spread. But by combining the regular butterfly with a 120-115 spread, you enter the 1-3-2 trade (1 long 125-put, 3 short 120-put, and 2 long 115-put).
The $0.82 debit from a butterfly and the $0.90 credit will leave you with 8 cents, even if the price goes beyond our price range.