A long butterfly spread is a neutral position that’s used when a trader believes that the price of an underlying is going to stay within a relatively tight range.
This spread is typically created using a ratio of 1-2-1 (1 ITM option, 2 ATM options, 1 OTM option).
Distance Between Short Strike & Long Strike - Debit Paid
Higher Long Option Strike - Debit Paid
Lower Long Option Strike + Debit Paid
At tastytrade, we tend to buy call or put butterfly spreads to take advantage of the non-movement of an underlying stock. This is a low probability trade, but we use this strategy when implied volatility is high, as the butterfly spread then trades cheaper. The spread trades cheaper in this situation since the price of the in-the-money option consists primarily of intrinsic value. Therefore selling the ATM options covers a higher percentage of the cost of purchasing both of the long options.
Since achieving maximum profit on a butterfly is highly unlikely, the profit target on this position is generally lower. A reasonable profit target on a long butterfly is 25-50% of the maximum profit.
Long butterfly spreads are low probability, low risk trades. For this reason, losses generally aren’t managed.
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