The Butterfly is a Option strategyThis is used to bet on the underlying being within a certain trading range on the expiration date. Depending on the market assessment, the speculation is thus mostly on a sideways movement or a moderately directional movement. The butterfly consists of four Options with three different base prices (3 Legs). In this article you will learn what exactly a Butterfly is and what to look for when trading a Butterfly.
Definition Butterfly
A butterfly is an option strategy in which two options are sold and one option is bought with a higher and one with a lower strike price. The strategy can be used both with Put options as well as with Call options are traded.
Most often, an at-the-money (or slightly out-of-the-money) strike price is chosen for the sale of the two options, thus speculating on a sideways movement and/or a declining implied volatility.
P&L diagram of a Butterfly
The profit and loss diagram of the Butterfly has the shape of a tent. The maximum profit occurs at the expiration date in the area of the top of the tent, which is at the price level of the two sold options.
What to look for when trading a Butterfly?
The purchase of a Butterfly is initially associated with costs, since the cost of the purchased options is higher than the income from the sold options. The maximum loss is limited to the costs (net debit). The maximum profit is significantly higher than the maximum loss. In order to realize this, however, the underlying must be quoted at exactly the same price level as the sold options on the expiration date. Therefore, option traders often close the trade earlier and realize a smaller profit.
Break Even Point
The further the underlying moves away from the price level of the sold options, the lower the profit. The two break even points can be calculated by subtracting the net debit from the price level of the long option with the higher strike price and adding it to the price level of the long option with the lower strike price.
Volatility
The development of the implied volatility (IV) plays an important role in a butterfly. The strategy has a negative Vega and thus benefits from a decline in the IV. Conversely, this means that opening a trade makes sense especially in an environment of high volatility or when volatility is expected to decline.
Time value expiry
If the underlying is between the strike prices of the purchased options (the highest and the lowest strike price), the probability of a profit increases with each day that passes. Thus, the butterfly profits from the time value decline of the options during the remaining term.