A butterfly option is an options strategy using multiple puts and/or calls to make a bet on future volatility without guessing in which direction the market will move. It is a combination trade constructed from three sets of either puts or calls having the same expiration date but different strikes or exercise prices. There are two basic types of butterfly option; long butterfly and short butterfly option.
Long butterfly is a type of butterfly option that can be created by either employing call options or all put options. Because of put-call parity, the long butterfly generated from call options will behave like a long butterfly that is created using put options. In short, in this type of butterfly option it really does not matter whether you employ calls or puts to build this type of butterfly option. This butterfly option is also a low risk strategy because when the stock crashes or creeps unexpectedly losses are just limited. The bad thing about this butterfly option is that this can yield limited profits
The long butterfly option can also be generated by buying an in-the-memory (ITM) call option or selling two at-the-memory (ATM) call options and or buying another out-of-the-money (OTM) call option. With the combination of the profit profiles from the butterfly option, the stock prices will fall which in turn can cause limited losses and if the stock prices jumps too high, limited losses can also be faced. However, a limited profit will suffice in the butterfly option in case the stock prices stay intact at the ATM option strike price. The trader can also use all put options rather than all call options in this butterfly option.
Short butterfly on the other hand is a butterfly option which is exactly the opposite of long butterfly. In this butterfly option, the trader receives maximum limited profits if the stock price falls and when the stock price is high, the trader receives limited profit. But in this butterfly option the trader is faced with a loss because the stock price doesn’t change much, though this loss is limited as well. This type of butterfly option is basically a strategy that is high in volatility but neutral in direction. Maximum loss for the short butterfly is incurred when at expiration; the stock price of the underlying stock remains unchanged while the maximum profit is obtained when the underlying stock price rally pass the higher strike price or falls below the lower strike price at expiration. The short butterfly is a neutral strategy but bullish on volatility. Short butterfly is also a limited profit and limited risk options trading strategy and can be constructed using calls or puts.
However, though butterfly option is a good option strategy, this could be expensive compared to other option strategies. A warning in both types of butterfly option is that, they involve buying and selling options at three strike prices. This means that the investor needs to pay three commissions to open the position and another three commissions in closing it. These extra commissions need to be considered to determine whether the butterfly will be profitable for any circumstance.
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