Butterfly options strategy :Everything you must to know

You might know that an option contract allows the holder to buy/sell the underlying asset at a predetermined price, called the strike price. The quantity of the underlying asset for the option contract is also predetermined. Once the contract expires, the holder can exercise the option or choose to ignore it. The butterfly option strategy is often used by investors interested in derivatives. It helps minimise the potential losses and enjoy good returns. Continue reading to understand the strategies in detail.

Topics Covered:

• What is the Butterfly Options Strategy?
• Butterfly Options Strategy
• In a Nutshell

What is the Butterfly Options Strategy?

It is essential to understand what is butterfly option strategy before delving deeper. A butterfly options strategy involves merging four options contracts to make profits from different price movements. The expiration date of all contracts in the butterfly strategy remains the same. The investor chooses three different strike prices for the four options contracts. While the investor purchases two options, they also sell two options in this strategy.

You must know that a call option allows the investor to buy the underlying security at the strike price. On the other hand, you can sell the underlying asset at the strike price on a future date with a put option. The butterfly strategy involves buying an option with a higher strike price and another option at a lower strike price. The investor must also sell two options with strike prices in the middle of the earlier two options. The idea is to restrict the risk and create more chances of profit with the help of spreading.

Butterfly Options Strategy

Here are the different butterfly strategies for options traders:

1.Long Call Spreading

The long-call strategy includes purchasing two call options, one with a higher strike price and another with a lower price. You must also sell two call options with medium strike prices. The medium strike price is between the above-purchased two call options. When the spot price or market price on the expiration date matches the medium strike price on two call options, you make the maximum profit. Also, the loss is limited to the premiums for options contracts.

2.Short Call Spread

You must purchase two at-the-money call options to exercise the short-call butterfly spread. At-the-money call options have medium strike prices, which are often equal to the spot or market price. You must also sell call options with a higher strike price. You must also sell another call option with a lower strike price. Unlike the above strategy, the short-call butterfly spread involves five options contracts. When the market price of the underlying asset on the expiration date is below the lowest strike price or above the highest one, you make the maximum profit. The maximum loss is limited to the strike price of the purchased call option (not including the premiums collected).

Additionally Read: Meaning of Demat Account

3.Long Put Spread

The long-put spread is an effective butterfly strategy for options investors. You must purchase two put options, one with a higher strike price and the other with a lower strike price. You must also write off (sell) two put options with a medium strike price. This strategy is somewhat similar to the long call strategy. The maximum loss with the long-put strategy is limited to the premium collected for the options. You create a net debt situation with this strategy, thus opening doors to profits.

Recommended Read: What is Options Trading

4.Short Put Spreading

You must sell a put with a lower strike price to implement the short put butterfly option strategy. You must also sell another put option with an increased strike price. The next step is to buy two put options with medium strike prices. Ensuring that the expiration date is the same for all four put options is crucial. You can make the maximum profit when the market price is below the lowest strike price or above the highest strike price. The premiums collected on selling put options are the maximum profit for this strategy.

5.Iron Butterfly Options Spread

You can use both calls and puts to implement the butterfly option strategy. You must purchase a call option with a higher strike price and a put option with a decreased strike price to implement this strategy. You must also sell an in-the-money call and a put option with the same expiration date. When the spot or market prices of the underlying asset remain at the medium strike price, you make the maximum profit. This options trading strategy is effective when the volatility is minimal in the market.

6.Reverse Iron Butterfly Options Spread

This butterfly options strategy involves purchasing an at-the-money call and a put (at-the-money) with increased and decreased strike prices, respectively. You must also write off an out-of-money call option with an increased strike price. Do not forget to sell another out-of-money put option with a lower strike price. When these four contracts have the same expiration date, it creates a net negative trade. This butterfly option strategy is perfect for markets with high volatility. You make the maximum profit when the spot price is above the maximum strike price or below the lowest strike price. The maximum loss is capped to the premium paid for purchasing the options.

Initiate demat account opening today to delve into sophisticated trading strategies like the Butterfly options strategy.

In a Nutshell

A butterfly option strategy can help combine different contracts to minimise losses. Also, the profits are maximised by combining call and put options with the same expiration date but different strike prices. The strike prices for the contracts must be adjusted to cap the losses and maximise profits. Beginners in the market must first understand the different butterfly strategies used by experienced options traders. Discover your preferred butterfly strategy now!