The Options Butterfly Strategy is one such strategy. It focuses on “covering all your bases” so to speak. It’s a great strategy for anyone who considers themselves a cautious trader. And, for those new to options trading it’d be a good idea to try it out. But, how do you know when to use butterfly option strategy?
In this article, we’ll cover what is a butterfly spread and the butterfly strategy options you should know. We’ll also discuss how to close a butterfly option spread as well as the differences between Butterfly Credit Spread vs. Butterfly Debit Spread.
What is a Butterfly Spread and How Does It Work?
Butterfly trading is an options strategy where you buy and sell a combination of call and put options with the same expiration date but different strike prices. This strategy aims to profit from a narrow range of price movements in the option’s asset.
First, the investor buys a call option with a low strike price. At the same time, they’ll sell two other call options with a higher strike price and then buys an additional call option with a higher strike price.
This way, the trader can profit if the price of the underlying asset remains stable. The investor earns a profit from the sold options, while the purchased options just expire worthless.
However, if the price moves outside of this very narrow range, the investor may not get the profits they seek but rather faces a loss.
When you use short or long call butterfly spread, it means you have specific beliefs about the movement of prices for a specific asset. But, this can be quite risky, since one never knows what the future holds. So, use long or short butterfly spread strategies with caution.
The Pros and Cons of Using the Butterfly Option Strategy
As mentioned earlier, a good options butterfly strategy will see you buying and selling two or more options contracts with different strike prices but the same expiration date. With them, the aim is to create a position that profits from a narrow range of price movements.
Pros of a Butterfly Call Strategy
- There’s a limited risk of losses. You only have to worry about losing your premium on the options call purchase.
- The potential profit from a good butterfly investment strategy is quite high if the underlying asset price remains within a specific price range.
- If you pick the best stocks for butterfly spread, you can use this strategy for bullish, bearish, or neutral market conditions.
Pros of a Butterfly Call Strategy
- Limited profit potential may discourage aggressive traders from using an option butterfly spread strategy.
- It’s quite complicated. Especially when you consider that one has to sell and buy multiple options contracts with the hope of specific consistent price ranges.
- Since you’re buying multiple options, there’ll be high commission fees to pay for each of them. This can eat into your profits.
- Those who know what is butterfly option strategy also know that it’s sensitive to time decay. If the underlying asset price remains the same, the value of the options contracts can decrease quickly over time.
When to Use the Butterfly Option Strategy: A Comprehensive Guide
Now that you know what is a butterfly option trading strategy, how do you use it? We’ll give you a guide on doing this for a daily or a weekly iron butterfly strategy.
Additionally, as mentioned earlier, it’s possible to use it for bullish, bearish, or even neutral markets. The goal is, after all, to profit from the underlying asset’s price remaining stable. Traders will be aiming for the stock price to be at a level with the strike price of the two options that were purchased at expiration.
The step-by-step guide to setting up a butterfly spread is as follows:
- Select the best stock for iron butterfly trading based on the current market price.
- Pick three strike prices with the same expiration date. The second strike price should be at or close to the stock’s current market price.
- Buy one call option at the lower strike price and one call option at the higher strike price.
- Use the sell butterfly spread strategy to sell two call options at the middle strike price.
- Calculate the cost of the options and their net debit.
Based on the above, it’s clear how the butterfly strategy has limited profit potential but also limited risk for losses. This makes it a popular strategy for conservative traders who want to take a neutral stance on a stock’s price movement.
How to Close a Butterfly Spread: A Step-by-Step Guide
Once you know what is butterfly spread is, you’re ready to close a butterfly spread. This involves selling previously purchased options contracts as well as buying back previously sold contracts. The steps for doing this are as follows:
- Find out the current market prices of the options contracts you previously bought and sold. Do this by looking at any reliable trading platform.
- Place sell orders on the options contracts previously bought. Do this for options contracts with the highest strike price, and another sell order for the options contracts with the lowest strike price.
- At the same time, place buy orders on the options contracts previously sold. Do this for the options contracts with the middle strike price.
- Verify the order and make sure you’re buying and selling the right options contracts.
- Calculate the profit or loss of the trade. Subtract the cost of the options contracts that you sold from the amount received from selling the options contracts you previously bought.
Butterfly Credit Spread vs. Butterfly Debit Spread: What’s the Difference?
The direction of the underlying price movement that each strategy is designed to profit from makes the main difference between Butterfly Credit Spread and Butterfly Debit Spread.
A butterfly debit Spread’s used for a bullish or neutral market. However, a butterfly stock option credit spread’s used for a bearish or neutral market. The net credit or debit created by the spread is also a distinguishing factor between the two strategies.
