Trading Options in Turbulent Markets: Master Uncertainty through Active Volatility Management

Chapter 18. The Butterfly Spread

So far you have learned about options spreads that involve buying and selling contracts with just two different strike prices. The butterfly spread is a strategy that involves four contracts with three strike prices. These are somewhat complicated trades, but they can be quite useful in either taking advantage of implied volatility or reducing your exposure to volatility. The butterfly spread offers low risk but also low reward. More important, the butterfly strategy can be a good investment in a time of high volatility because as implied volatility increases, the butterfly spread becomes less expensive to create. Hence you don't have to fear the butterfly spread because of its complexity. You aren't likely to lose much if the market goes south in any case, and in an unpredictable marketplace the butterfly can offer a measure of security. The butterfly spread makes a profit if the share price for the underlying stock remains mostly unchanged when the contracts in the spread expire.

Setting up a Butterfly

When you make a risk chart of a butterfly spread, you see an investment strategy that looks like a butterfly, with a body and a pair of wings. In a long butterfly contract, the strike prices for the contracts you buy form the wings, and the lower price for the contracts you sell make up the body. For a short butterfly, the short contracts make up the wings. Setting up the butterfly involves four different options contracts with three strike prices, ...