Butterfly Spread
Candlefocus EditorA butterfly spread is a popular options trading strategy used by investors and traders to take advantage of market neutral positions and limit risk while maximizing potential profits. It is composed of four option contracts that consist of either two calls or two puts of the same expiration date but with three different strike prices. The two outer strikes are equidistant from the at-the-money (ATM) strike, forming the wings of the butterfly.
The butterfly spread is considered a neutral strategy because it is designed to pay off regardless of the direction of the underlying asset. This is a marked contrast to long or short positions, which are subject to the risk of loss if the market moves against their position.
The strategy is best used when the underlying asset is not expected to move much before the option's expiration date. It pays off the most when the price of the underlying asset stays close to the ATM strike price. If the underlying asset moves further away from the ATM strike price, the spread will start to lose money.
To create a butterfly spread, an investor first buys a call at the lower strike price with a long position and then sells two calls at the middle, or at-the-money strike, and finally buys a call at the higher strike price. Alternatively, a butterfly spread can also be created using put options.
There are several advantages to using butterfly spread strategies. The main advantage is that they provide risk control. The profitability of the strategy is capped at the difference in the lower and higher strike prices multiplied by the number of contracts purchased. They also provide a defined risk, as a trader knows the exact amount they can potentially lose or gain before they enter the trade. Finally, this strategy can be used to buy time and take advantage of market positions without having to commit a great deal of capital.
Overall, the butterfly spread is a great option for investors seeking to capitalize on market movements without taking on too much risk. It is a versatile strategy that can be used in a variety of different markets and provides investors with the flexibility to exploit market neutrality and generate returns.