🦋 What Is a Butterfly Spread in the Stock Market? A Complete Guide with Examples
If you’re exploring advanced options trading strategies, chances are you’ve come across the butterfly spread. This versatile strategy is favored by traders who expect low volatility in the price of an underlying stock or index. The butterfly spread offers limited risk and reward, making it ideal for experienced investors looking for neutral market plays.
In this blog post, we’ll break down:
- What a butterfly spread is
- The components of a butterfly spread
- Examples with real numbers
- Variations like the Iron Butterfly and the Broken Wing Butterfly
- Pros and cons of using this strategy
🦋 What Is a Butterfly Spread?
A butterfly spread is an options trading strategy that combines both bull and bear spreads using three different strike prices but with the same expiration date. The structure typically includes four options contracts (either all calls or all puts).
This strategy is used when a trader believes the price of a stock will stay close to a specific value (called the “center strike”) by expiration.
🔍 Structure of a Long Call Butterfly Spread
Let’s say a stock is currently trading at $100.
Here’s how you might set up a long call butterfly spread:
- Buy 1 call at $95 (lower strike)
- Sell 2 calls at $100 (middle strike)
- Buy 1 call at $105 (higher strike)
All contracts have the same expiration date.
This creates a “tent-shaped” profit-loss graph, where the maximum profit occurs at the middle strike price ($100 in this case).
📈 Profit and Loss of a Butterfly Spread
| Outcome | Explanation |
|---|---|
| Max Profit | Occurs if the stock closes at the middle strike ($100) |
| Max Loss | If the stock moves below $95 or above $105 |
| Breakeven Points | $95 + net debit paid and $105 – net debit paid |
| Risk | Limited to the net premium paid |
| Reward | Limited; depends on the difference between strikes |
💡 Real Example: Call Butterfly Spread
Imagine a stock is trading at $100, and you want to set up a butterfly spread:
- Buy 1 $95 call for $7
- Sell 2 $100 calls for $4 each
- Buy 1 $105 call for $1
Net Debit (Cost) = $7 – $8 + $1 = $0
In this case, the position costs nothing to enter (rare but possible), and your maximum profit could be $5 if the stock ends at $100.
🔁 Put Butterfly Spread
This is similar to the call butterfly spread, but uses put options:
- Buy 1 lower strike put
- Sell 2 middle strike puts
- Buy 1 higher strike put
It profits if the stock stays near the middle strike at expiration. The logic, risks, and rewards are the same, just executed with puts.
🛠 Variations of the Butterfly Spread
Butterfly spreads have a few important variations you should know about:
🧲 Iron Butterfly Strategy
The Iron Butterfly is a popular variation that combines calls and puts:
Setup Example (Stock at $100):
- Sell 1 $100 call
- Sell 1 $100 put
- Buy 1 $105 call
- Buy 1 $95 put
This strategy creates a net credit when opened.
- Max Profit: Occurs if the stock ends at $100 (the strike of sold options).
- Max Loss: If the stock moves below $95 or above $105.
- Breakeven Points: $95 and $105 (adjusted slightly by premium received)
💡 The Iron Butterfly is like selling a straddle and buying protection on both sides.
🦋 Broken Wing Butterfly Strategy
The Broken Wing Butterfly (BWB) is a twist on the traditional butterfly that adjusts the strike prices to reduce risk on one side while maintaining a net credit or reduced cost.
Call BWB Example:
- Buy 1 $95 call
- Sell 2 $100 calls
- Buy 1 $107 call (instead of $105)
Here, the wings are not symmetric. You have a “broken wing” on the higher side.
Advantages of Broken Wing:
- Often opened for a credit
- No risk on one side of the market
- Good for traders with a directional bias, but still want some profit if the market stalls
🎯 When to Use a Butterfly Spread
This strategy is ideal when:
- You expect low volatility
- You have a neutral outlook on the stock
- You want to limit your risk
- You’re targeting a specific price range
✅ Pros and ❌ Cons
✅ Pros:
- Limited risk and reward
- Can be low-cost or even generate a credit
- Good for range-bound trading
❌ Cons:
- Profits are capped
- Requires precision (stock must end near the middle strike)
- Can involve multiple commissions
🔎 Comparing Butterfly Strategies
| Strategy | Risk | Reward | Best For |
|---|---|---|---|
| Call Butterfly | Limited | Limited | Neutral/Low Volatility |
| Put Butterfly | Limited | Limited | Neutral/Low Volatility |
| Iron Butterfly | Limited | Limited | Income strategy, credit-based |
| Broken Wing Bfly | Lower on one side | Limited | Directional with protection |
📊 How to Manage a Butterfly Spread
Managing a butterfly spread involves watching price movements closely:
- If price nears middle strike: Hold till expiration for max profit
- If price breaks out: Consider closing early to reduce losses
- Time decay (theta) helps this strategy when price stays flat
🔧 Tools to Use
Platforms like Thinkorswim, Tastytrade, and TradingView allow you to:
- Simulate butterfly trades
- Analyze risk/reward graphs
- Monitor time decay and volatility
🧠 Final Thoughts
The butterfly spread is a powerful strategy for experienced options traders who have a neutral outlook. Whether you’re using a standard long call/put butterfly, an Iron Butterfly for income, or a Broken Wing Butterfly for a directional bias, these strategies provide defined risk and a clear path to profit.
While they may seem complex at first, mastering butterfly spreads can help you:
- Trade with confidence in low-volatility markets
- Limit your exposure
- Gain greater flexibility with advanced positions