What is a Butterfly Spread? A Simple Guide
A butterfly spread is a low-cost, defined-risk strategy that profits when the underlying finishes near a target strike. A long call butterfly buys one lower call, sells two middle calls, and buys one higher call. The payoff peaks at the middle strike.
A butterfly spread is a cheap, precise bet that a price will settle near a specific level. It offers a good risk-reward if you are right about the target.
Read on for a simple breakdown built for beginners. You can trade it on Stockk.
Key Takeaways
- It profits when price finishes near a target strike.
- Buy one lower, sell two middle, buy one higher option.
- The payoff peaks at the middle strike.
- It is low-cost with small defined risk.
- The profit zone is narrow.
How does a butterfly spread work?
Imagine NIFTY trades at 22,600. You buy the 22,400 call at ₹290, sell two 22,600 calls at ₹180 each, and buy the 22,800 call at ₹95. The net cost is ₹25, which is also your maximum loss. If NIFTY finishes exactly at 22,600, the profit peaks at ₹175. The position is profitable between the breakevens at 22,425 and 22,775.
Where the profit comes from
The two sold middle options collect premium, while the two bought outer options cap the risk on each side. The payoff peaks if price finishes at the middle strike and falls off symmetrically. The cost is low and the maximum loss is the small net premium paid, making it a cheap pin bet.
When to use it
A butterfly suits a precise expectation that price will settle near a specific level by expiry, with low movement. It is inexpensive and offers a favourable risk-reward if the target is hit. The trade-off is that the profit zone is narrow.
Butterfly at a glance
| Item | Butterfly spread |
|---|---|
| Maximum profit | At the middle strike |
| Maximum loss | Small net premium paid |
| Best when | Price settles near the target |
| Profit zone | Narrow |
If you want to act on butterfly spread and other strategies, you can do it through Stockk. Setting up a demat account takes only a few minutes, and Indira Securities handles the backend. Browse the Knowledge Center to keep learning.
Futures and Options are leveraged products and carry a high risk of loss that can be more than the money you put in. This article is only for learning and is not a recommendation to trade in derivatives.
Frequently Asked Questions
How is a butterfly spread structured?
It buys one lower and one higher option and sells two middle options, so the payoff peaks at the middle strike with small defined risk.
What is the maximum profit?
It is reached if price finishes at the middle strike at expiry, where the peak is sharp. Movement away reduces profit.
What is the maximum loss?
It is the small net premium paid to enter, capped by the outer options. Risk is low.
When is a butterfly ideal?
When you expect price to settle near a specific level with low movement. It is cheap with good risk-reward, but the zone is narrow.
How is it different from an iron butterfly?
A butterfly uses all calls or all puts; an iron butterfly mixes calls and puts. Both peak at the middle strike.
Investments in securities market are subject to market risks. This article is for educational purposes only and does not constitute investment advice.
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