What is a Butterfly Spread?
A Butterfly Spread is a neutral options strategy that is profitable when the stock price stays near the middle strike price. You can execute a Butterfly Spread using either call options or put options, but you must use the same type for the entire spread (all calls or all puts).
- Buy one call/put option at a lower strike price (e.g., $90).
- Sell two call/put options at a middle strike price (e.g., $100).
- Buy one call/put option at a higher strike price (e.g., $110).
How Payoff Works (Calls):
If you use call options, the Butterfly Spread profits when the stock price is close to the middle strike price. If the stock price goes too high or too low, your losses are limited to the net debit (cost) of the spread.
How Payoff Works (Puts):
If you use put options, the Butterfly Spread profits when the stock price is close to the middle strike price. If the stock price moves too far above or below the middle strike price, your losses are limited to the net debit (cost).
Example Payoff Scenarios for Calls:
- Initial Setup: You pay a net debit of $200 (for simplicity, assume $2 per share).
- Stock Price = $85 (below lower strike price):
- All call options expire worthless because the stock price is below all strike prices.
- Net Payoff: You lose the entire net debit paid of $200. Total payoff = **-$200**.
- Stock Price = $100 (at middle strike price):
- The call at the lower strike price ($90) is exercised, and you profit from the difference between $100 and $90 ($1,000).
- The calls sold at $100 expire worthless, and the call at the higher strike price ($110) also expires worthless.
- Net Payoff: Profit of $1,000 from the lower strike call, minus the net debit of $200. Total payoff = **$800**.
- Stock Price = $115 (above higher strike price):
- The call at the lower strike price ($90) is exercised for a profit.
- The calls sold at $100 are in the money, resulting in a loss.
- The call at the higher strike price ($110) limits further losses.
- Net Payoff: You lose the net debit paid of $200. Total payoff = **-$200**.