Abutterfly spread is created by selling two options and buying one option farther out-of-the-money (OTM) and one option farther in-the-money (ITM). The butterfly can be created with calls or puts. The two sold options are called the body of the butterfly, and the two long options are the wings of the butterfly. Butterfly spreads are quite versatile and may be used in speculative directional trading or for delta-neutral income generation trading.
AT-THE-MONEY AND OUT-OF-THE-MONEY BUTTERFLY SPREADS
If we establish a butterfly with calls, we have effectively put on two vertical spreads. The lower half of the butterfly is a bull call spread, while the upper half is a bear call spread; put another way, we have bought one call spread and sold another call spread where the calls sold in each spread are at the same strike price. Your online broker probably has a butterfly order screen where this entire position may be entered as a single order. Alternatively, you could enter two separate orders for the two vertical spreads that make up the butterfly spread.
We can create a butterfly spread with put options in the same way with one butterfly order or by selling the lower put spread (a bull put spread) and buying the upper put spread (the bear put spread). In this case, the puts sold in both spreads will be at the same strike price.
Figure 8.1 displays the risk/reward graph for a call butterfly spread on the Russell 2000 Index (RUT) on February 23, 2010, with ...