A butterfly is an appropriately-named option strategy because it sounds like it should have wings. It does. And the wings go in either direction away from the body. You can see the resemblance when you look at the profit curve.
The trade is put on by selling two call options (the body) which are sandwiched between two long call options -- one above the body and one below the body. The calls purchased are called the wings. All told, there are three legs to the trade, each with a different strike price.
When using this strategy, the trader is predicting the underlying stock will trade close to the body's strike price the day that all the options expire.
Trading the Butterfly Spread
There is a narrow range in which this strategy is profitable. Ideally, on the day of expiration, the stock will be selling at the body's strike price. This will result in the largest possible gain on the strategy.
Since time decay is positive, many people trade butterflies close to expiration.
Traders typically close out the positions prior to expiration.
Because butterflies have three legs, the bid-ask spreads play a big role in putting on, and taking off, the trade. If the option is thinly traded, spreads will be wider and the cost of liquidity will be high. Make sure that each option has sufficient volume and avoid butterflies using low-volume options.*
Picking the Right Butterfly Spread
Normally, the intervals between each of the three strikes should be the same.
True to the strategy's reputation as an "exotic trade", there are many variations to the basic butterfly.
- If you sell the calls slightly in the money it will cost you less but make it a somewhat bearish trade
- If you sell the calls slightly out of the money it will cost you less but make it a somewhat bullish trade
How to Finish
If you hit the sweet spot with a butterfly, the options you sold will expire worthless (that's good for you) along with the out-of-the-money call you bought (that's not good) and all you need to do is sell the remaining in-the-money call option. If you don't do this, by the way, before expiration, it will automatically exercise and you will take delivery of the stock.
*These examples omit the costs associated with trading options, and you'll need to figure that into your overall returns. At Zecco Trading, options commissions are just $4.50 per trade and $0.50 per contract.