Warrior Trading Blog

Butterfly Spread Definition: Day Trading Terminology

When it comes to profiting from stock movement, there are different strategies which can be used thanks to their ability in combining buy and sell call and put options. This can happen at different strike prices and expiration dates. One common strategy is known as a butterfly spread.

In day trading, a call refers to an option contract which provides the trader with the right to purchase the underlying security at a particular strike price at any point until the expiration date.

A put is defined as an options contract that provides the owner with the right to sell an underlying asset at a particular strike price at any point until the expiration date.

On the other hand, a butterfly is defined as a limited risk and non directional options strategy that has a high probability of earning limited profit. This happens only when the underlying asset is expected to be higher or lower.

What is a butterfly spread?

This is a complex spread which can combine a near term bull spread with a long term bear spread with the end goal of profiting from a change in term structure.

It can also be defined as a neutral option strategy that combines both bear and bull spreads. It achieves this by using four option contracts that have a similar expiration but with three different strike prices. This is done to create a wide range of prices with the objective of making a profit.

Day traders can sell two option contracts in the middle of a strike price and also buy an option contract at a higher strike price and another at a much lower strike price.

Furthermore, the butterfly spread is known to have a limited risk. The only time you can make higher returns is when the underlying asset’s price is similar to the strike price of the middle options. This is why option trades are structured to have a higher chance of earning profits even though it is a small profit.

Types of butterfly spread positions

There are two

1. Long
2. Short

1.Long butterfly spread

A long butterfly spread is designed to have three parts with a total of four options. They include

a. Single long call with a lower strike
b. Short calls with middle strike
c. Single long call with higher strike

One thing you need to note is that all the above calls have the same expiration while the middle strike is always located between the higher and lower strikes. According to day traders, this is considered long because of the net cash outlay is required to start. When the strategy is implemented correctly, there is a higher chance of gaining more.

In option trading, the total cost of the long option is done by multiplying the net debt of the strategy by the number of shares that each contract represents. Its maximum profit is calculated by subtracting the net debit from the difference found between lower and middle strike prices. This means that the maximum risk is limited to the net debit paid for this position.

2. Short position

When it comes to the short position in butterfly spreads, there are two:

i. Short butterfly put

In this case, two long put options of the same class are multiplied by the price together with the expiration date. You can offset the value by one short put option that has a higher strike price and another with a lower strike price. To ensure success, all components need to have the same expiration and underlying asset.

ii. Short butterfly call

When it comes to a short butterfly call, two long call options from the same class are usually multiplied with the strike price and expiration of an underlying asset. The value is then offset by a single short call option with a higher strike price and another with a lower strike price.

Why use the butterfly spread

Veteran traders use the strategy to speculate changes in terms of the options contracts structure and not by the movements of the underlying asset. Since the understanding of the term structure changes, experience is required especially when it comes to single markets.

This happens on extended periods of time which is not usually undertaken by retail option traders.

It is common for options traders to speculate that midterm contracts will decline against both long and short term. When the strategy is used, it helps to lower margin requirements which open ups more avenues to profit from.

Benefits of butterfly spreads

a. It helps to lower margin requirement. This helps to increase your return on investment
b. It provides more avenues of profit which improves the levels of probability for earning higher profits
c. Has limited risk
d. Combines both bear and bull spreads
e. Maximum profits and loss are predictable

Final Thoughts

Options traders generally use the strategy when they expect prices of midterm options to fall. This is usually relative to long and short term contracts.

The best news is that the term structure happens in both normal and inverted markets as a result in the shift that influences supply and demand. This shift is affected by seasonal factors. Thanks to this, you have the chance of increasing your ROI.