The Butterfly Spread

This page is both a blog post (Oct 13, 2011) and Introductions to Options; Part 16.
[Video below]

I’ve never taken time to discuss the butterfly spread as a separate trade. There are two basic reasons.

First, I seldom use butterflys and thus tend to ignore it’s significance in the options world. It’s a very popular strategy, and for that reason alone it is worthy of discussion. Today’s post and video presents ‘butterflys for the options rookie.’

Second, the butterfly spread is essentially a condor, and I did not believe that a separate discussion was necessary.

However, it is often difficult for new traders to recognize the similarities, and it’s time for Options for Rookies to talk/write about the butterfly spread. Option books usually include the butterfly spread as a separate chapter, so now it’s our turn.

Definitions

a) Each butterfly or condors consists of one LONG call (or put) spread and one SHORT call (or put) spread. Each spread uses options with the same underlying asset and expiration date.

    NOTE:These positions are only calls or only puts

b) All spreads have the same width. In example 1 below, that width is 10 points

c) In the butterfly, the long and short spreads share a common strike. In example 1, that’s the 90 strike. We are long the XYZ Dec 80/90 call spread and short the XYZ Dec 90/100 call spread

d) In the condor, there is some distance (which is NOT defined) between the two spreads. There can be any number of strike prices between the long and short spreads. In this example, it is 10 points. NOTE: That distance is not related to the spread width. It is a coincidence that each is 10 points in Example 1.

Summary: The butterfly is a condor. The only difference is that there is a separation between the strike prices of the long and short spreads in the condor, and there is none (the spreads have one strike price in common) in the butterfly.

Example 1

    Butterfly
    Buy 1 XYZ Dec 80 call
    Sell 2 XYZ Dec 90 call
    Buy 1 XYZ Dec 100 call

    Condor
    Buy 1 XYZ Dec 80 call
    Sell 1 XYZ Dec 90 call

    Sell 1 XYZ Dec 100 call
    Buy 1 XYZ Dec 110 call

    NOTE

Butterflys are equivalent to iron butterflys
Condors are equivalent to iron condors
(Proof follows)

Example 2

a) Regular butterfly

    Long 5 SPX Jan 1050 calls
    Short 10 SPX Jan 1100 calls
    Long 5 SPX Jan 1150 calls

b) Iron butterfly

We know that buying a call spread is equivalent to selling a put spread, when the underlying asset, strike prices, and expiration date are identical. Thus, we can substitute a short put spread for the long call spread and the resulting positions are equivalent.

When we are short one call spread and one put spread, then we own the ‘iron’ variety of the spread. In other words, we have substituted one equivalent spread for another. The butterfly is long one call (or put) spread and short another. The iron butterfly is short one call spread and short one put spread, with the condition that each of these spreads has a common strike price.

    The iron butterfly (or condor) is short one put spread and short one call spread. In Example 2, they share the 1100 strike.

    Long 5 SPX Jan 1050 puts
    Short 5 SPX Jan 1100 puts

    Short 5 SPX Jan 1100 calls
    Long 5 SPX Jan 1150 calls

The iron butterfly is short one STRADDLE and long the two ‘wings’ (HI and LO strikes)
The iron condor is short one STRANGLE and long the ‘wings’

The Video

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