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Butterfly Spread

  • A neutral strategy involving a combination of both a bull spread and a bear spread
  • Can be implemented using just calls, just puts or a combination of both
  • Requires small investment, has limited risk and reward. Profits larger than potential risk
  • There are four contracts and three strike prices involved in the spread
  • Best when stock is near the middle strike; keep debit low
  • Best butterfly spreads are found on more expensive/volatile stocks with strike prices 10-20 points apart

Using only calls

  • Buy one call at lowest striking price, sell two calls at the middle strike price and buy one call at the highest strike price
  • Example:
    • Buy 100 strike call for 12
    • Sell two 110 strike calls for 6 each
    • Buy 120 strike call for 3
  • Spread will cost net debit of 3
  • Max profit on expiration will be if the stock is at the short strike i.e. 100. In this case:
    • 100 strike will be worth 10 points (intrinsic value), 2 point loss
    • Two short calls will expire worthless, 12 point profit
    • 120 strike will be worthless, 3 point loss
    • Net 12 - 2 -3 = 7 point profit
  • Max loss is limited to initial debit of 3
  • Downside break even = lowest strike + debit
  • Upside break even = highest strike - debit