Option trading explained: The butterfly strategy
This page explains the butterfly option trading strategy. It shows how to put on a butterfly and discusses the situations when to do it.
The butterfly options position is in some ways similar to the straddle. Both strategies are used when you expect a big move in the price of the underlying but are not sure of the direction. Both strategies are symmetrical, ideally around the present price of the underlying. The difference is that the butterfly is more cautious than the straddle. It is therefore also cheaper to put on. A straddle is more profitable the bigger the price move is. A butterfly has a limited profit. If the price of the underlying moves beyond a certain point away from the center of the butterfly, the profit ceases to increase.
As explained in the pages about straddles, most pay off profiles can be achieved in several ways. The two most common ways to construct a butterfly will be shown here. The pay off profile of the butterfly changes angle in 3 different places. This means we have to use 3 different strikes to create the butterfly option trading strategy.
The butterfly pay off diagram looks as below. Pretty obvious why it’s called a butterfly. Before you read any further, see if you can figure out how to put it together. You already know it takes options with different strike prices. In addition ask yourself how many options you need to change the angle 3 times.
Ill Butterfly pay off diagram
Look at the left half of the butterfly. It looks like a short call option. Let’s take that as the starting point. Once we have a short call option we have the left “wing” of the butterfly option trading strategy. As with the straddle we now need to bend the pay off profile at the center. From downward sloping to upward sloping. Let’s assume that the price of the underlying is 100$ and so we want to center the butterfly around this price. To get the pay off profile symmetrical, the left and right strikes should be on equal dollar distances from the center strike.