Debit/Debit Spread Trades

The butterfly option is a sophisticated option trade that achieves its maximum gain when the underlying stock remains flat.

The butterfly option can seem rather complicated to grasp. But the easiest way to understand it is to note how it’s actually constructed. It is comprised of a bull call spread and a bear call spread.

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A further quirk is that the bull call and bear call spreads are written so that the short call portions of each spread are both at the money.

Typically, the long portion of these bull and bear spreads would be written at the money or even a little out of the money, and the short portion of the spreads would be written out of the money. You make money if and when the stock moves toward the strike price of these secondary, short out of the money options.

With the butterfly option, you also make money as the stock moves toward the strike price of the short calls. But since the stock is already at that strike price (at the money) when you set up the trade, it’s already where you want it to be. Therefore, you don’t want it to move.

It’s a strange little spread. By constructing an overlapping bull call spread and a bear call spread. you seem to be betting that the stock will both go up and go down, all the while hoping that neither happens. You make the maximum amount of profit when the stock finishes where it starts—when all the options expire worthless except for the one in the money call.

Butterfly Spread Setup

Butterfly Spread Setup:

• Buy 2 call options — one in the money and one out of the money
• Sell 2 call options — both at the money

• A net debit is produced, which is the maximum amount you can lose
• Maximum gain occurs if the stock finishes at the strike price of the 2 short calls — everything would expire worthless except for the single in the money call

Butterfly Option Example

EXAMPLE: The XYZ Zipper Company is trading around $40/share. You expect (hope) that the stock will remain relatively flat in the near term.

You essentially open a bull call spread (buying a $35 in the money call for $6/contract and selling/writing an $40 at the money call for $1.50/contract) followed by opening a bear call spread (selling another $40 at the money call for $1.50/contract and buying a $45 out of the money call for $.50/contract).

Excluding commissions, the long call butterfly spread in this example generates a debit of $3.50. It costs $350 to set up—$600 to buy the in the money call plus $50 to buy the out of the money call minus the credit you receive for writing the two calls At the money for $300 ($1.50 x 2).

Ideally, if the stock closes at $40/share, all the calls expire worthless except for the one you purchased with the $35 strike price which would end $5 in the money. As a result, the butterfly option that cost you $300 to set up ends up with a final value of $500.

That’s the best case scenario. If the stock doesn’t stay flat and instead moves very much in either direction, you can quickly lose your entire original investment:

• If, for example, the stock closes at $35/share (or below), all four calls (and your entire position) would expire worthless.
• If the stock closes at $45/share (or above), you also lose all of your original investment. The math: At $45/share, your $35 long call is worth $1000 and your $45 long call is worth nothing. The two $40 short calls are both $5 in the money and are therefore also worth $1000. They cancel out your in the money call.

Option Butterfly Variations

The butterfly option can also be constructed using puts rather than calls. The risk/reward profile is essentially the same. You would sell or write two at the money puts, and buy two puts, one in the money and one out of the money.