The options market can be used to take advantage of volatility in a underlying asset. Similarly, options can be marshaled to take advantage of a lack of volatility, as an investor bets that an asset will hold near a particular price. Butterfly strategies can be used in both cases.
In previous sections we described how to create bull and bear spreads. These option strategies are meant to take advantage of a particular direction that a stock is expected to go, either up or down. Butterflies work differently. Instead of taking advantage of a particular outlook for the direction of the price of the underlying asset (either a bullish or bearish prediction), butterflies take advantage of either volatility or a lack of volatility, depending on how it is constructed. In effect, a butterfly combines a bull spread and a bear spread. The strategy can be created using either calls or puts.
A butterfly is created by combining four options of the same type, either four calls or four puts. There are three strike prices involved in the strategy. Options with higher and lower strike prices are known as the "wings," while a middle strike price is known as the "body."
A Long Butterfly takes advantage of a situation where the investor expects a stock to be at a particular price at expiration. In general, the strategy is used to take advantage of a low volatility situation. The Long Butterfly is constructed by selling two options (either puts or calls) for a particular strike price. Meanwhile, a third option is simultaneously purchased at a higher strike price, and a fourth is purchased at a lower strike price.
The closer the stock is trading to the strike price for the body at expiration (the middle strike price), the closer to the maximum profit is achieved. The investor is betting the stock price will be at or near a certain point at expiration.
In a Long Butterfly, there is a net cash outlay to set up the strategy. Any profits are realized later. The worst case scenario would be if the price of the underlying asset was sitting outside the span of the wings at expiration. At that point, the investor would receive nothing for the trade and would be out the original premiums paid.
The Short Butterfly is utilized when high volatility is expected. The investor is betting that the underlying asset will make a move, but the direction of the move is unknown. A Short Butterfly is constructed by buying two options (either calls or puts) at a certain strike price. Simultaneously, the investor sells a third option at a higher strike price and a fourth at a lower strike price.
In the Short Butterfly, the investor is long the body and short the wings, as opposed to the Long Butterfly, where the investor is short the body and long the wings. The names are given in reference to the wings - the Short Butterfly is short the wings (the higher or lower strike prices).
Cash is generated in the Short Butterfly when the trade is made. Any potential losses are incurred later. If the stock rallies above the strike price of the higher wing, or falls below the strike price of the lower wing, the investor keeps the cash generated at the outset.
If the price at expiration is within the span of the wings, a payout would be necessary that might mitigate or eliminate the initial cash received. The worst case scenario would be if the stock was sitting at the body strike price at expiration.
The following show two examples, one for the Long Butterfly and one for the Short Butterfly. They're taken from a recent expiration for SPY. The stock price is $210.00 and the at-the-money strike price is 210, with a price of $3.50. The in-the-money call strike is at 205, with a price of $7.25, and the out-of-the-money call strike is at 215, with a price of $1.25.
For the Long Butterfly, we would sell 2 at-the-money calls and buy 1 each of the in-the-money and out-of-the-money calls.
The Short Buttefly is the opposite, buying 2 at-the-money calls and selling 1 each of the in-the-money and out-of-the-money calls.
The Iron Butterfly is a variation on the butterfly strategy, with the difference being that it combines both puts and calls. A typical Long Iron Butterfly would be constructed by selling an at-the-money call and an at-the-money put at the same strike, along with buying an out-of-the-money call and an out-of-the-money-put.
The benefit of a Long Iron Butterfly is that the trader would receive net credit for selling at-the-money options, which carry the most premium, and buying out-of-the-money options, which carry the lowest premium. Otherwise, the same environment of low expected volatility would be the best for establishing a Long Iron Butterfly strategy.
A Short Iron Butterfly would be in effect, the opposite, buying the at-the-money options, and selling the out-of-the-money.