butterfly

A butterfly is a volatility bet that the trader can implement to protect against large fluctuations, or to gain on volatility. You will notice that a butterfly is almost like a straddle, with a difference in the edges. The traders can add additional contracts to his/her strategy to reduce the risk of large losses or gains for more protection.  A butterfly can be executed in different ways: with puts only, calls only, or a mix of both.

What are its components?

A long butterfly can be created in three ways:

  • Butterfly with puts only
    • Buy Put at strike price 1
    • 2 x Sell Put at strike price 2
    • Buy Put at strike price 3
  • Butterfly with calls only
    • Buy Call at strike price 1
    • 2 x Sell Call at the strike price 2
    • Buy Call at strike price 3
  • Butterfly with puts and calls
    • Buy Put at strike price 1
    • Sell Put at strike price 2
    • Sell Call at strike price 2
    • Buy Call at strike price 3
  • (*A short butterfly can be created by implementing the reverse strategies above)

When and why should I have a butterfly?

You should have a butterfly if you expect to see a lot of fluctuation in the underlying asset’s price. Creating a butterfly does not infer that you have a specific view on the stock. It simply implies that the trader expects a lot of volatility and executed a strategy to gain something from it. You can create a short butterfly if you do not expect any fluctuations.

What does it look like graphically? What is the payoff and profit graph?

butterfly

What is the break-even point?

The break-even point of a butterfly can be defined by finding the stock price where the butterfly generates a zero-dollar profit. By adding all contracts and equating it to zero, you should solve for ST. However, there is a possibility where a region of stock prices can break-even. To find this region, you should create scenarios to define the payoffs. For example, the payoff when ST<30, 30<ST<40, 40<ST<50 and 50<ST.

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