A butterfly spread consists of a total of three options. One buys a call with a lower strike price, in-the-money, a call with a higher strike price, out-of-the-money, and sells two calls with a middle strike price., at-the-money. All the calls have the same expiration date.
The spread can be used either with calls or puts. For sake of brevity, this writer will just use the call options example.
Break-Even Point, Maximum Profit, and Maximum Loss
- Break-Even Point: the first break-even point is the lower strike price + the net cost of the premium paid
- The second break-even point is higher strike price – the net cost of the premium paid
- Maximum Profit: Occurs when, at expiration date, the stock has not moved. The in-the-money call will have intrinsic value, while the other calls will expire worthless.
- Maximum Loss: The net premium paid
Example of a Butterfly Spread: Dow Chemical
Assume the stock is trading at 29.31, and the month is February. One buys 1 June 27 Call @4.10 x 100(one contract =100 shares) =410. One buys 1 June 31 Call @1.88 x 100 = 188. One sells 2 June 29 Calls @2.64 x 200 = 528. The net cost of trade: 598 (410+188) – 528 = $70
- First break-even point: 27 + .70= 27.70
- Second break-even point: 31-.70 = 30.30
- Maximum Profit: When the underlying stock equals the middle strike of 29. 29(price one sold the stock at) – 27(the price one bought the stock at) - .70 (cost of trade) = 1.30 x 100 = 130
- Maximum Loss: Will occur if, at expiration, the stock is under the lowest strike of 27, or higher than the highest strike (31). If lower than 27, and one has the right to buy it at 27, one would be foolhardy to do so, so it will expire worthless, as well as all the other options. Likewise, if the stock goes above 31, any gains made from the two calls bought will be offset by the loss from the two short calls. The loss will then be limited to the net premium paid of $70
The Butterfly Spread is a Combination of a Bull Call Spread and a Bear Call Spread
The Bull Call Spread consists of buying a call option while simultaneously selling a higher strike out-of-the-money call option of the same stock and the same expiration month. An investor will notice that this scenario is occurring here: One bought a June 27 call, and sold a higher call with a strike price of 29.
A Bear Call Spread: Bear call spreads are typically created by buying a option of a certain price, and selling an option at a lower strike price. This scenario is also happening here: one bought a June 31 option, and sold a June 29 call option.
Bruce Silver - Bruce Silver has been an investor in stocks and stock options since high school. As he says" I prefer to trade calls; I am an optimistic ...
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