Traders can use several types of butterfly option strategies to lower risk and make money. All of them, however, have three strike prices and four option contracts that share an expiration date.
The higher and lower strike prices always have an equal distance from each other. For example, you might have strike prices of $45, $50, and $55. You will notice that the values increase by $5. But you can choose other distances, which will affect risk and reward.
In the above example, you would call $50 your at-the-money strike price. The $45 represents your lower strike price. The $55 represents your higher strike price.
A butterfly option strategy can include a combination of calls and puts. They may also include in-the-money and out-of-money options.
Because butterfly spreads can take many forms, they give you opportunities to make money regardless of how a stock’s value changes. You do, however, need to guess whether the price will stay within or outside of a certain range. That range is the butterfly. You can think of the range as stretching from one tip of a butterfly’s wing to the tip of the opposite wing.
Since there are several types of butterfly option spreads, let’s look at a few examples to get a better understanding and decide which options you want to try.
What Is a Long Call Butterfly Option Strategy?
A long call butterfly option strategy involves:
- Purchasing an in-the-money call option (the low strike price)
- Writing two at-the-money call options
- Buying an out-of-the-money call option (the higher strike price)
For example, you can initiate a long call butterfly option strategy by writing two call options at $30, buying a call at $25, and buying a second call at $35. The investor earns money when the stock price is above or below $30 by a certain amount.
To make the most money, the stock would need a value of $30. As long as the stock’s value doesn’t fall outside of the range, though, the investor earns a profit.
What Is a Short Call Butterfly Option Strategy?
A short call butterfly option strategy involves:
- Selling an in-the-money call option (the lower strike price)
- Purchasing two at-the-money call options
- Selling one out-of-the-money call option (the higher strike price)
In this situation, you want the stock’s value to fall outside of your range at expiration.
If the value falls within the range, then the lower strike gets initiated while the others become worthless.
As long as the value is higher than the higher strike price, you can initiate it to pocket the premium.
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What Is a Long Put Butterfly Option Strategy?
A long put butterfly option strategy involves:
- Buying a put (the lower strike price)
- Selling two at-the-money puts
- Buying a put (the higher strike price)
Much like the long call butterfly option strategy, you want the stock’s value to fall as close to the middle as possible. The investor will earn the most money when the stock’s value is equal to the two at-the-money puts.
If the stock’s value falls outside of the spread at expiration, then the investor doesn’t make anything. The total loss, therefore, would equal the premiums and any commission paid to the brokerage.
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What Is a Short Put Butterfly Option Strategy?
A short put butterfly option involves:
- Writing an out-of-the-money put option (the lower strike price)
- Buying two at-the-money puts
- Writing one in-the-money put option (the higher strike price)
When using a short put butterfly strategy, an investor can earn money when a stock’s value lies outside of the spread at expiration. When the value is lower than the lower strike price or higher than the higher strike price, the investor earns premiums.
The investor will lose the most money when the stock’s value equals the higher strike price.
What Is an Iron Butterfly Spread Option Strategy?
An iron butterfly spread involves:
- Buying one out-of-the-money put option (the lower strike price)
- Writing one at-the-money put option
- Writing an at-the-money call option
- Buying one out-of-the-money call option (the higher strike price)
Obviously, this approach covers a lot of bases. Most investors choose it when they believe a stock will experience low volatility between the investment and the expiration.
Investors earn the most money from an iron butterfly spread when the stock’s value equals the at-the-money put and call options. The further the stock’s value strays from the middle, the less the investor will earn.
The investor will lose the most money when the stock’s price equals or exceeds the out-of-the-money call option. In this case, the investor loses the amount of the call option as well as any premiums owed to the brokerage.
Since you have at least five butterfly option strategies to learn, it may take you some time to master the concepts. Unless you already have a lot of experience as an investor, you shouldn’t expect to understand the mechanics of every strategy. You will, however, learn quickly.
The good news is that butterfly option strategies don’t force you to choose specific stock values. That means you can use them to learn more about stock movements without putting much money at risk. Ideally, they will help you earn money. Even if you don’t, you can limit your losses while you grow as an investor.
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How To Place Butterfly Option Spreads
To place iron butterfly spreads, long call butterfly option spreads, short call butterfly spreads, long put butterfly spreads, or short put butterfly option strategies, you will want to select a broker who understands complex options strategies. Not all brokers are created equal so choose wisely.
Some brokers like Robinhood are excellent for beginner stock and options traders but offer very basic orders and tools. Others are aimed at experienced options traders. Not only are the tools more advanced but you will be able to visualize risk and reward more easily by using risk graphs.
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