Understanding Butterfly Spread

Now, we’ve already seen three spread strategies in this module - bull ratio spread, bear ratio spread, and calendar spreads. In this chapter of Smart Money, we’re going to take a look at another major options spread strategy - the butterfly spread trading strategy. It is very unique, versatile, and is highly adaptable to different kinds of market movements. That said, here’s an in-depth look at the butterfly spread options strategy.

What is a butterfly spread?

The butterfly spread is an options trading strategy that combines two other spread strategies - bull spread and bear spread. The strategy is market neutral and works best when the market itself has low volatility. And so, you get to enjoy maximum profits only when the market doesn’t move by much prior to expiry. The butterfly spread trading strategy is designed to limit the downside risk and provide you with limited profits.

How to set up a butterfly spread?

A butterfly spread involves four options contracts with three different strike prices, but with the same expiration date. And, all of the three strike prices should be equidistant from each other. Here’s how a typical butterfly spread looks.

• Purchase 1 lot of in the money (ITM) call options 
• Sell 2 lots of at the money (ATM) call options 
• Purchase 1 lot of out of the money (OTM) call options

This particular options trading strategy is known as a long call butterfly spread and is just one among five major variants of butterfly spreads. The other ones are called short call butterfly spread, long put butterfly spread, short put butterfly spread, and iron butterfly respectively.

Let’s now take a look at the short call butterfly spread. Here’s how you can set it up.

• Sell 1 lot of in the money (ITM) call options 
• Purchase 2 lots of at the money (ATM) call options 
• Sell 1 lot of out of the money (OTM) call options

As you can see, the short call butterfly spread is basically the inverse of the long call butterfly spread.

Moving on, here’s how you can set up a long put butterfly spread.

• Purchase 1 lot of in the money (ITM) put options 
• Sell 2 lots of at the money (ATM) put options 
• Purchase 1 lot of out of the money (OTM) put options

And similarly, here’s a quick look at the short put butterfly spread.

• Sell 1 lot of in the money (ITM) put options 
• Purchase 2 lots of at the money (ATM) put options 
• Sell 1 lot of out of the money (OTM) put options

And as for the iron butterfly, we’ll be skipping it for now since we already have a separate chapter dedicated entirely towards the options trading strategy.

How does the butterfly spread work?

Got a fair idea of how to set up a butterfly spread trading strategy? Let’s take a look at how it works using an example. As always, here are some of the assumptions that we’re going to make.

• You’re interested in the stock of Godrej Consumer Products Limited. 
• You wish to set up a long call butterfly spread. 
• The stock is currently trading at Rs. 710. 
• The lot size of the options contract of this stock is set at 1,000.
• The expiry date for all the options contracts that we’re going to take up would be May, 2021.

Now, to execute a long call butterfly spread, here’s what you need to do.

• Purchase 1 lot of in the money (ITM) call options, which in this case would be GODREJCP MAY 700 CE. Assume that the premium for this contract is at Rs. 31 per share. To purchase 1 lot (which is 1,000 shares) of ITM call options, you would have to pay Rs. 31,000 (Rs. 31 x 1,000).
• Sell 2 lots of at the money (ATM) call options, which in this case would be GODREJCP MAY 710 CE. Assume that the premium for this contract is at Rs. 26 per share. So, by selling 2 lots (which is 2,000 shares) of ATM call options, you would receive Rs. 52,000 (Rs. 26 x 2,000).
• Purchase 1 lot of out of the money (OTM) call options, which in this case would be GODREJCP MAY 720 CE. Again, assume that the premium for this contract is at Rs. 20 per share. To purchase 1 lot (which is 1,000 shares) of OTM call options, you would have to pay Rs. 20,000 (Rs. 20 x 1,000).

As you can see from the strike prices above - Rs. 700, Rs. 710, and Rs. 720. They’re all equidistant from each other. Now, once you execute all of these three options, you would end up with a net credit of Rs. 1,000 (Rs. 52,000 - Rs. 31,000 - Rs. 20,000). Remember this.

Now let’s take up three different scenarios and see how the long call butterfly spread performs.

Scenario 1: The share price falls down to Rs. 700 on expiry

Here’s a quick look at what would happen if the share price of Godrej Consumer Products falls down to the lowest strike price out of the three options.

• The ITM call options - GODREJCP MAY 700 CE that you purchased would expire worthless since the strike price and the spot price are the same.
• The ATM call options - GODREJCP MAY 710 CE that you sold would also expire worthless since the strike price is higher than the spot price.
• The OTM call options - GODREJCP MAY 720 CE that you purchased would again expire worthless since the strike price is higher than the spot price.

The total net profit that you get to enjoy in this situation would ultimately come up to Rs. 1,000, which is the net credit amount that you’re left with after executing the above three options.

Scenario 2: The share price rises up to Rs. 720 on expiry

What if the share price of Godrej Consumer Products rises up instead? Here’s what would happen in this case.

• The ITM call options - GODREJCP MAY 700 CE that you purchased would make a profit of Rs. 20 per share, which would amount to Rs. 20,000 (Rs. 20 x 1,000).
• The ATM call options - GODREJCP MAY 710 CE that you sold would incur a loss of Rs. 10 per share, which would amount to Rs. 20,000 (Rs. 10 x 2,000).
• The OTM call options - GODREJCP MAY 720 CE that you purchased would expire worthless since the strike price is the same as the spot price.

The total net profit that you get to enjoy in this scenario would again come up to Rs. 1,000, which is the net credit amount that you’re left with after executing the above three options.

Scenario 3: The share price stays at Rs. 710 on expiry

Let’s now take a look at what you end up with if the share price of the company stays at Rs. 710 without moving either side.

• The ITM call options - GODREJCP MAY 700 CE that you purchased would make a profit of Rs. 10 per share, which would amount to Rs. 10,000 (Rs. 20 x 1,000).
• The ATM call options - GODREJCP MAY 710 CE that you sold would expire worthless since the strike price is the same as the spot price.
• The OTM call options - GODREJCP MAY 720 CE that you purchased would also expire worthless since the strike price is higher than the spot price.

The total net profit that you get to enjoy would come up to Rs. 11,000 (Rs. 10,000 + Rs. 1,000).

Wrapping up

As you can see from the above, the long call butterfly spread turns up the maximum amount of profit only when the share price doesn’t move by much. That said, it also offers some protection from downside risk by preventing your positions from going into a loss due to unfavourable market movements on either side.

Now that you’re aware of how the butterfly spread trading strategy works, you can try testing this options strategy by coming up with some stock market scenarios of your own. And while you’re at it, you could also see how the other variants, namely the short call butterfly spread, long put butterfly spread, and short put butterfly spread works.

A quick recap

• The butterfly spread is an options trading strategy that combines two other spread strategies - bull spread and bear spread. 
• This strategy is also market neutral and works best when the market itself has low volatility. 
• The butterfly spread is designed to limit the downside risk and provide you with limited profits. 
• A butterfly spread involves four options contracts with three different strike prices, but with the same expiration date.
• All of the three strike prices should be equidistant from each other
• There are five major variants of butterfly spreads, namely the long call butterfly spread, the short call butterfly spread, the long put butterfly spread, the short put butterfly spread, and the iron butterfly.