Butterfly Spread

A butterfly spread consists of multiple options traded at 3 varying strike prices, with double the amount of options at the middle strike price. It should be constructed using all calls or all puts. A butterfly spread constructed from a mix of calls and puts is known as an Iron Butterfly Spread. Any “long” butterfly spread position is a bet on low volatility: the underlying asset price will remain within the range until expiration. A “short” butterfly spread is a bet on high volatility: the underlying asset’s price escaping that range.  Loss and profit each have a maximum potential value for all butterfly positions.

How To Read/Interpret Option Diagram
The first option is purchased at a lower strike price, two options are sold for every option purchased at a middle strike price, and an equal number of options are purchased at a higher strike price as the lowest strike price. The underlying asset is uniform across all options. The lowest strike price option purchased and highest strike price option purchased are equidistant from the sold middle strike price options.

As long as the underlying asset price stays exactly at the two sold middle options, the maximum profit will occur at expiration or the closing of the position. If the underlying asset price falls or rises profits will decrease. If the underlying price moves too far from the strike price of the two sold options, loss will occur until it reaches the maximum potential loss value.

A long butterfly has two breakeven points. The first is the strike price of the higher long option minus premium paid, and the second is the strike price of the lower option plus the premium paid.

How To Read/Interpret Option Diagram
The short butterfly reverses the long butterfly’s order sequence, but maintains its setup. The first option is sold at the lower specific strike price, two options are purchased for every single option sold at a middle strike price, and 1 option is sold at a higher strike for each option purchased at the lowest strike price.

As long as the underlying asset price stays exactly at the two sold middle options, the maximum loss will occur at expiration or the closing of the position. If the underlying asset price falls or rises losses will decrease. If the underlying price moves too far from the strike price of the two sold options, profit will appear and increase until it reaches the maximum potential gain value.

Short butterfly breakeven points function differently than long butterfly options. The first is the strike price of the higher short option minus premium earned, and the second is the strike price of the lower option plus the premium earned.

Butterflies and Assignment

For butterflies, early assignment may result in a complete dismantlement of this position. The risk appears for both long and short butterflies, since each is constructed from short options. This risk from assignment is highest when the share price is above the lowest strike price purchased options and the sold options, but below the highest strike price. Utilizing European style options, typically used for Indexes, will allow you to run this trade without worrying about assignment.