Guide on How to Earn with Butterfly Spreads

Table of Contents

• Overview of Butterfly Spreads
• Call and Put Butterfly Spreads
• Constructing a Butterfly Spread
• Profit Scenarios for Butterfly Spreads
• Real-World Examples
• Benefits and Risks
• Managing and Adjusting Butterfly Spreads
• Summary

Overview of Butterfly Spreads

A butterfly spread is a non-directional options strategy combining two vertical spreads (a bull spread and a bear spread) to cap both gains and losses. It uses four options at three strike prices (often in a 1–2–1 ratio). For example, a long call butterfly buys a lower-strike call, sells two calls at a middle strike, and buys a higher-strike call. The payoff is limited-risk, limited-reward: you make the most profit if the underlying finishes exactly at the middle strike, and you lose only the small net premium paid if it finishes outside the outer strikes.

Because of this structure, a butterfly has a clear price target and a known maximum loss. Traders often use butterflies when they expect a calm market (low volatility). If implied volatility is high when entering and then falls (as often happens after earnings or news), butterflies tend to gain value. Conversely, if the market jumps beyond the wings, the loss is still capped at the premium, protecting against large adverse moves.

Butterflies work on both stocks and indices. Index options (e.g. S&P 500) are usually cash-settled with no early exercise, while stock options can be exercised early (especially before dividends), which traders should watch. Otherwise, the payoff diagram is the same for any underlying.

Call and Put Butterfly Spreads

Butterflies can be constructed with either all calls or all puts (they have the same payoff by put-call parity). We focus on the long-butterfly (net-debit) version:

• Call Butterfly: Buy 1 lower-strike call, sell 2 calls at the middle strike, and buy 1 higher-strike call (same expiration). Net debit. It profits if the stock ends near the middle strike; losses are limited beyond the wings.
• Put Butterfly: Buy 1 higher-strike put, sell 2 puts at the middle strike, and buy 1 lower-strike put. Also a net debit. Same payoff shape: maximum profit at the middle strike, limited loss outside the wings.
• Bias: Centering the middle strike at your expected price gives a neutral position. If the middle strike is above the current price, the butterfly is slightly bullish (stock needs to rise); if below, it’s slightly bearish. Most traders set the middle strike to their target price.

(Buying the wings and selling the body is the “long” butterfly. The inverted strategy – selling the wings and buying the body – is a short butterfly, a net-credit strategy that profits from large moves instead. We will not cover that here.)

Constructing a Butterfly Spread

1. Select strikes: Pick three strikes (lower, middle, upper) around your target price.
2. Enter the legs: Buy 1 option at the lower strike, sell 2 at the middle strike, and buy 1 at the upper strike. Use all calls or all puts, same expiration.
3. Net cost: The position is entered for a net debit (you pay a premium), which is also your maximum risk.
4. Max reward: The maximum profit per share is (upper strike – lower strike) minus the premium paid (achieved if the underlying ends at the middle strike).
5. Equal spacing: Strikes are typically evenly spaced (e.g. $90–$100–$110). A non-even spacing (a “broken-wing” butterfly) will skew the payoff and risk profile, which is an advanced variation.

For example, with strikes $90–$100–$110 and a $2 premium paid, the maximum profit is (110–90)–2 = $18 per share (achieved at $100), and the maximum loss is $2 (if the stock is at or outside $90 or $110).

Profit Scenarios for Butterfly Spreads

The payoff of a long butterfly is highest at the middle strike and tapers to losses on either side. Key points:

• Maximum profit: When the underlying equals the middle strike at expiration (the sold options expire worthless and one of the longs is fully ITM).
• Breakeven points: Lower strike + premium paid, and upper strike – premium paid. (Between these breakevens, the butterfly is profitable.)
• Maximum loss: When the underlying is at or beyond the outer strikes (all options expire worthless or offset), the loss equals the premium paid.
• Volatility effect: A long butterfly is net short vega. It benefits if implied volatility falls (reducing option premiums) and suffers if volatility spikes after entry.
• Time decay: The strategy is net long theta. If the price stays near the middle, the short options lose time value faster than the long ones, aiding profit.
• Greeks: Net delta is roughly zero at entry. Gamma is highest near the middle strike (small moves cause big P/L changes there), and positive theta helps over time.

In short, a long butterfly profits only in a narrow range around the middle strike; outside that range, it simply loses the small premium.

Real-World Examples

Example 1 (Call Butterfly): Suppose a stock is at $100. You set up a 90-100-110 call butterfly by buying 1 $90 call for $12, selling 2 $100 calls at $7 each, and buying 1 $110 call for $4. Net cost = $2. At expiration:

Stock @ Expiration	P/L per share	Explanation
$90 or below	–$2 (max loss)	All calls expire worthless (loss = $2).
$92	$0	Breakeven: $90 call is $2 ITM (covers cost).
$100	+$8 (max profit)	$90 call is $10 ITM; profit = 10–2 = $8.
$108	$0	Breakeven (upper).
$110 or above	–$2 (max loss)	Loss capped at $2 (the premium).

Example 2 (Put Butterfly): Using the same strikes and $2 debit, a 90-100-110 put butterfly has this payoff:

Stock @ Expiration	P/L per share	Explanation
$90 or below	–$2 (max)	Loss capped at premium.
$92	$0	Breakeven: $110 put is $18 ITM (covers cost).
$100	+$8 (max)	$110 put is $10 ITM; profit = 10–2.
$108	$0	Breakeven (upper wing).
$110 or above	–$2 (max)	All puts expire worthless (loss = $2).

In these examples we ignored commissions and assumed no early exercise. In practice, trading four legs incurs costs, and stock options may be assigned. The key takeaway: between about $92 and $108 the butterfly is profitable (up to $8), but beyond that range you lose the $2 premium. The same logic applies to index or ETF butterflies using index points instead of stock price.

Benefits and Risks

• Limited Risk: Maximum loss is the premium paid (capped).
• Low Cost and Margin: Small upfront cost (premium) and low extra margin (if fully paid). The initial debit is the total risk.
• Higher Probability of Small Profits: Any ending price between the wings yields some profit, so butterflies often see a small gain more often than directional bets.
• Profits from Stability: Best in low-volatility, range-bound markets. Falling implied volatility after entry boosts profitability.
• Time Decay Advantage: Net long theta – time decay helps the trade if price stays near target.
• Limited Profit & Narrow Range: Upside is capped and only achieved if the underlying lands near the middle strike. Missing that narrow zone yields little or no profit.
• Complexity & Costs: Four legs means higher commissions and margin checks. Stock butterflies have early-exercise risk around dividends, so manage short positions carefully.

Managing and Adjusting Butterfly Spreads

• Monitor Price: Track the underlying vs. your strikes. If it drifts far from the center, consider rolling or closing.
• Roll or Adjust: You can roll the butterfly to new strikes or a later expiration. Narrow or widen the wings to adjust bias (e.g. shift bullish or bearish).
• Close Early: If the position reaches a target profit (e.g. 50% of max gain), consider closing to lock it in. If it moves beyond breakeven, exit to avoid eroding value.
• Profit/Loss Targets: Plan exits with specific targets or stops (e.g. half the max profit, or twice the debit). With defined max gain/loss, you can set clear risk/reward levels.
• Assignment and Volatility: Watch for early exercise on short options (especially around dividends). If a big event or volatility spike comes, be prepared to adjust or exit, since the butterfly will lose value.
• Greek Management: Initially delta-neutral, but as price moves the position can develop directional bias. Rolling or adding hedges may be needed if delta moves too far from zero.

Summary

• Butterfly spreads are market-neutral, limited-risk strategies using four options at three strikes (a 1–2–1 structure).
• Constructed with calls or puts, buying one wing, selling two middle, buying one wing. It costs a net premium (debit).
• Maximum profit occurs if the underlying ends at the middle strike; losses are capped at the premium if it ends outside the wings.
• Breakevens are tight (middle strike ± premium), so profit only comes in a narrow price range.
• Best in stable, low-volatility markets. Time decay works in your favor. Falls in implied volatility help.
• Benefits: small upfront cost, known risk, and higher chance of a small gain. Drawbacks: limited payoff, trade complexity (4 legs), and early exercise risk on stocks.
• Suitable for stocks and index options alike (index versions are cash-settled with no early exercise).
• Always plan carefully: pick strikes to match your price target, set profit/loss exit rules, and manage the position as the market moves.