A butterfly spread is a neutral option strategy combining bull and bear spreads.

Butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from. The trader sells two option contracts at the middle strike price and buys one option contract at a lower strike price and one option contract at a higher strike price.

Hughes Optioneering

Both puts and calls can be used for a butterfly spread. Butterfly spreads have limited risk , and the maximum losses that occur are the cost of your original investment. The highest return you can earn occurs when the price of the underlying asset is exactly at the strike price of the middle options.

Option trades of this type are structured to have a high chances of earning a profit, albeit a small profit. A long position in a butterfly spread will earn profit if the future volatility of the underlying stock price is lower than the implied volatility.

A short position in a butterfly spread will earn a profit when the future volatility of the underlying stock price is higher than the implied volatility. By selling short two call options at a given strike price, and buying one call option at an upper and one at a lower strike price often called the wings of the butterfly , an investor is in a position to earn a profit if the underlying asset achieves a certain price point at expiration.

A critical step in constructing a proper butterfly spread is that the wings of the butterfly must be equidistant from the middle strike price. The amount of premium paid to enter the position is key.

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