What is a Butterfly Spread?
A butterfly spread is a limited-risk, limited-reward strategy that profits when the stock stays near a target price. It combines bull and bear spreads to create a position with defined risk and a narrow profit zone.
Long Call Butterfly Structure:
- Buy 1 ITM Call (lower strike)
- Sell 2 ATM Calls (middle strike)
- Buy 1 OTM Call (higher strike)
Example: Stock at $100 → Buy 95 Call, Sell 2x 100 Calls, Buy 105 Call
Long Put Butterfly Structure:
- Buy 1 OTM Put (lower strike)
- Sell 2 ATM Puts (middle strike)
- Buy 1 ITM Put (higher strike)
Why Use Butterfly Spreads?
- Low Cost: Small debit required
- High Reward: 5:1 to 10:1 risk/reward possible
- Defined Risk: Max loss = debit paid
- Neutral Bias: Profit from range-bound stocks
When to Use Butterflies:
- Stock in tight range, expect continuation
- After big move, expecting consolidation
- High IV rank (cheaper debit)
- Target price near current price
Strike Selection:
- Wings Width: 5-10 points on stocks, 25-50 on indices
- Center Strike: Near current price or target
- Debit: Should be 20-30% of wing width
- DTE: 30-60 days optimal
Management Rules:
- Take profit at 50-75% of max gain
- Cut loss at 50% of debit paid
- Adjust strikes if price moves significantly
- Exit with 1-2 weeks before expiration
Iron Butterfly vs Butterfly:
- Iron Butterfly: Uses both calls and puts, credit spread
- Regular Butterfly: All calls or all puts, debit spread
- Iron Fly: Wider profit zone, higher capital requirement