A butterfly spread is a well-known options strategy that involves bull and bear spreads combined to create a market-neutral position. It is used to earn profits within a given price range while restricting potential losses.
How a Butterfly Spread Works?
The method uses four option contracts with the same expiration date but three different strike prices. The configuration consists of:
- Buying one lower-strike option
- Selling two middle-strike options
- Buying one higher strike option
This creates a profit zone within the middle strike range and limits both maximum loss and maximum gain. A butterfly spread can either be created through call options or put options, whichever is preferred.
Advantages of a Butterfly Spread
One of the key aspects of this strategy is that it has a very low risk. Because the maximum profit and loss are established, traders know exactly what their potential exposure can be. Another advantage is that butterfly spreads typically call for less capital investment than other strategies that have the same risk-reward characteristics.
Conclusion
Butterfly spread is commonly utilised by traders when they don’t anticipate any major price action of an asset until expiry. It is most effective in situations of low volatility when the price is anticipated to stay in a small range.
Although the potential for profit is restricted, the managed risk and intentional placement are why the butterfly spread is a useful resource for options traders who wish to earn steady returns with very little exposure.
