Options trading offers investors the flexibility to profit from price movements in financial assets. Strategies like the butterfly option strategy help in managing risk and maximising returns in various market conditions. Let us understand its working, execution, and potential outcomes.
What is the butterfly option strategy
The butterfly strategy is employed by options traders who anticipate minimal movement in the price of the underlying asset. In this strategy, traders buy and sell three options contracts simultaneously. All of them have different strike prices but the same expiration date.
The purpose of using this strategy is to profit from a limited range of price movement in the underlying asset. Now, let us understand the basic components of a butterfly strategy:
ATM option
- This is the option purchased at the money.
- This means its strike price is closest to the current price of the underlying asset.
OTM option
- These are the options sold at strike prices above and below the ATM option.
- These options will typically be equidistant from the ATM option.
Further OTM option
- This is the additional option purchased.
- It has a strike price even further from the current price of the underlying asset than the two sold options.
Let us see the working in three steps:
Step I: Buy one option | Step II: Sell two options | Step III: Buy one option |
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Butterfly strategy example
An options trader believes that the stock of XYZ Ltd. will trade within a narrow range in the near term. The current price of XYZ Ltd. is Rs. 1000 per share.
How will the trader set up the butterfly spread?
Buy 1 ATM call option
- Buy one call option with a strike price of Rs. 1000 and an expiration date one month away.
- This is the at-the-money (ATM) option.
Sell 2 OTM call options
- Sell two call options with strike prices of Rs. 1050 and Rs. 1100, respectively, expiring in one month.
- These are the out-of-the-money (OTM) options.
Buy 1 further OTM call option
- Buy one call option with a strike price of Rs. 1150, expiring in one month.
- This is the further out-of-the-money (OTM) option.
Now, let us analyse this trade set-up under three different scenarios:
Scenario 1: Price remains within the range (Rs. 1000 - Rs. 1100)
- If the price of XYZ Ltd. stays between Rs. 1000 and Rs. 1100 until expiration, the trader profits.
- The sold options expire worthless, while the purchased options gain value due to their proximity to the ATM option.
- The maximum profit is achieved if the price settles exactly at Rs. 1100 at expiration.
Scenario 2: Price goes above Rs. 1100
- If the price of XYZ Ltd. rises above Rs. 1100, the maximum loss occurs.
- The sold options become in-the-money (ITM).
- This event results in losses that are partially offset by the profits from the purchased options.
- Also, the losses are limited due to the purchased options.
Scenario 3: Price drops below Rs. 1000:
- If the price of XYZ Ltd. falls below Rs. 1000, the maximum loss occurs again.
- In this scenario, the ATM option expires worthless, while the purchased options also lose value.
- However, the losses are limited due to the purchased options.
What are the different types of butterfly trading strategies
Butterfly spreads are a family of options trading strategies. There are several variations of butterfly spreads, each with its unique characteristics and applications. Let us explore some of the common types:
Types | Execution | Timing |
Long call butterfly spread |
| Used when the trader expects the price of the underlying asset to remain stable, with a slight bias towards one direction. |
Long put butterfly spread | Similar to the long call butterfly spread, but using put options instead of call options. | Used when the trader anticipates minimal movement in the price of the underlying asset. |
Short call butterfly spread |
| Used when the trader expects the price of the underlying asset to remain within a specific range, with no significant movement. |
Short put butterfly spread | Similar to the short call butterfly spread, but using put options instead of call options. | Used when the trader anticipates minimal movement in the price of the underlying asset. |
When is the maximum profit realised
In all the above cases, the maximum profit is achieved if the price of the underlying asset is equal to the middle strike price at expiration.
Conclusion
Butterfly option strategy offers various ways to profit from expected price stability in an underlying asset. Whether it is through long or short call/put butterfly spreads, traders can effectively execute these strategies and maximise their earning potential.
However, as with all forms of futures and options trading, butterfly strategy also comes with risks. Thus, traders must remain cautious and start by practising with small positions. Continuous learning and monitoring the market is the key that can significantly improve the chances of success.
