Butterfly spread strategies give traders powerful ways to engage the futures and options markets. Featuring applications for trading both bullish and bearish opinions, these types of spreads are ideal for limiting risk while pursuing nearly any financial goal. However, be forewarned―the market doesn’t hand out free lunches, and spread trading is no exception.
What Is a Butterfly Spread Option Strategy?
A butterfly spread is the combination of multiple bull and bear spread options strategies. Essentially, it’s a “net-neutral” market play because calls and puts are bought and sold simultaneously. In the event that the underlying asset’s price doesn’t exceed an expired range at expiry, the position closes in the money. If an unexpected breakout occurs, the total risk is the contract premiums plus the written exposure.
Although classified as “neutral,” butterfly option strategies boast a multitude of functionalities. You can easily take bullish or bearish positions in the market by adding calls and puts to the position. This strategy is accomplished by buying and selling different quantities of contracts with the same expiration at three different strike prices. The contracts that are targeted have out-of-the-money (OTM) and at-the-money (ATM) strikes.
To illustrate the basic mechanics of this strategy, let’s take a look at a bull call butterfly spread. Assume that Carey expects this year’s corn crop to be relatively normal, coming in near regional five-year averages.
Accordingly, Carey looks for CME December corn to move higher but remain beneath the five-year top of 750’10. In the spring, December corn is trading near 550’0. To execute the bull call butterfly, Carey does the following:
- Purchases one ATM December corn call with a strike of 550’0 for $0.16
- Sells two OTM December corn calls with strikes of 650’0 for $0.06
- Purchases one OTM December corn call with a strike of 750’0 for $0.02
In all, Carey purchases two December corn calls and sells two December corn calls. The cost of executing this bull call butterfly spread is as follows:
- Buy one ATM December corn call at 550’0 for $800 (5000*$0.16)
- Buy one OTM December corn call at 750’0 for $100 (5000*$0.02)
- Sell two OTM December corn calls at 650’0 and realize $600 ((5000*$0.06)*2)
To execute this butterfly spread, it’s going to cost Carey a net of $300 (($800+$100)-$600 = $300). In addition to commissions and fees, the minimal liability is attractive―so what is Carey’s upside?
The goal of this bull call butterfly is to capitalize on a measured appreciation of December corn while limiting risk. As you can see, the purchased calls are each 100’0 away from the written OTM calls. This establishes Carey’s position―if December corn goes off the board above 550’0 and at or below 650’0, Carey maximizes profits.
However, there is a downside to this strategy. If the market proves to be an outlier and prices rally above 750’0, the spread becomes a net loser. Although unlikely, surprise weather patterns, monetary policy shifts, trade wars, and pandemics are all capable of sending prices directional. Should a black swan event occur, Carey will need to address the situation as it unfolds.
Learning How to Trade Options Takes Time and Effort
Compared to buying stocks or trading outright futures, advanced options strategies such as the butterfly spread can be confusing. In order to execute them competently, it is imperative that you first boost your options IQ.
A great way to learn the ins and outs of options is by reading Daniels Trading’s Futures & Options Strategy Guide. Featuring in-depth analysis of 21 futures and options trading strategies, it’s essential reading for anyone interested in engaging these exciting markets.