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.
Directional Assumption: Neutral
Setup: This spread is typically created using a ratio of 1-2-1 (1 ITM option, 2 ATM options, 1 OTM option).
- Buy Call/Put (above short strike)
- Sell 2 Calls/Puts
- Buy Call/Put (below short strike)
Ideal Implied Volatility Environment : High
Max Profit: The distance between the short strike and long strike, less the debit paid.
How to Calculate Breakeven(s):
- Upside: Higher Long Option Strike - Debit Paid
- Downside: 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.
When do we close Butterflies?
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.
When do we manage Butterflies?
Long Butterfly spreads are low probability, low risk trades. For this reason, losses generally aren’t managed.
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