Butterfly

A butterfly is a complex and low-risk trading strategy involving four options. The long trader buys two options at different strike prices and sells two options at the same strike price. The strike price of the options sold lies between the ones which are bought. Usually, the premium received from selling of options offsets the premium paid to buy the options. So, it is also a cost neutral strategy. A long butterfly pays when the volatility reduces and time decays set in.

Types: It can be classified based on the options used for construction and side of the trade. So, we have four variations for butterfly trading strategy.

  • A Long Call Butterfly is constructed by buying two call options at different strike prices and selling two call options at the same strike price.
  • A Long Put Butterfly is constructed by buying two put options at different strike prices and selling two put options at the same strike price.

The long trader will gain from the strategy if the market remains rangebound and his loss is limited to the premium paid if the market moves. It is a low-risk strategy. The profit from a long butterfly, irrespective of how it is constructed, is as shown below:

Long Butterfly

  • A Short Call Butterfly is constructed by selling two call options at different strike prices and buying two call options at the same strike price.
  • A Short Put Butterfly is constructed by selling two put options at different strike prices and buying two put options at the same strike price.

The short trader will gain the initial premium paid if the market moves in either direction and will lose if the market remains rangebound. The risk reward ratio for a short trader is not very good in this strategy. The profit from a short butterfly is as shown below:

Short Butterfly

Uses: It is used in the scenarios similar to where straddle/strangle is used. A long butterfly can be used where normally a short straddle/strangle is used. The advantage of a long butterfly is that the downside is limited, while in the case of a short straddle/strangle it is unlimited. Of course, this advantage comes at a price of a lower upside. Such a strategy suits low-risk traders.

A short butterfly can be used where normally long straddle/strangle is used. But the risk to reward ratio is not very beneficial in case of a butterfly. The downside is lower than a long straddle/ strangle though.

References:

 Book: 

Options, Futures and Other Derivatives by John C Hull


Last updated on : August 31st, 2017
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