My Quest to Build a Million Dollar a Year Income Stream with Options Trading

Profiting on Low Volatility – The Long Butterfly Spread

The long butterfly spread is an options trading strategy that involves using three different strike prices to create a position that profits from low volatility in the underlying stock price. 

It’s considered a neutral strategy because it’s designed to profit when the underlying stock price remains within a certain range. This strategy can be made from either calls or puts to construct a symmetric payoff profile.

How to setup a Long Butterfly Spread

You are going to open this strategy with three different positions, one long call, two short calls of the same strike price, and finally another long call, all with the same expiration date, and on the same stock. 

long butterfly spread at jpm

Buy one lower strike option (in-the-money call)

Sell two middle strike options (at-the-money calls)

Buy one higher strike option (out of-the-money call)

You want the two long calls to be equidistant from the short calls. This helps cap your maximum loss potential to just the initial debit when you open the position.

How to Profit from a Long Butterfly Spread 

The payoff diagram of a long butterfly spread resembles the wings of a butterfly. You open the position as a debit, and this represents your maximum loss potential.  

What you want is for the stock to stay right around where it is when you open the position. This is because you realize your maximum profit if the stock price finishes right at the middle strike price. 

Maximum Loss Potential of a Long Butterfly spread

You only lose on a long butterfly spread when the stock price moves significantly higher or lower from the middle strike price.

If the stock price falls below the lowest call position, all three positions expire worthless and you are only out the initial debit. There are no additional losses if the stock craters before expiration.

On the other end, if the stock price skyrockets, and exceeds the highest call position, the lowest call position and the middle short position cancel each other out.  You would be out the initial debit, and that’s it.

How does that work?  Using the example order entry I showed, the lower long position is at a strike price that is two dollars less than the middle strike price.  The lower option is always going to be worth $2 more than the short position.  

As the stock price moves above the short position, because it is made of two contracts, it increases in value at a rate that is twice that of the lower position.  But because the lower position starts out $2 higher in value, the stock price needs to move more than $2 higher than the middle strike price before the short position starts to be valued higher.  

But this is also where our higher long position sits. So when the stock price increases beyond the highest strike price, you have two long calls and two short calls increasing at the same rate.  No matter how high the stock price goes from there, they will always cancel each other out. 

This is why your maximum potential loss from this strategy is just the initial debit. 

When to Use the Long Butterfly Spread

You might consider using a long butterfly spread when you expect the underlying stock price to remain relatively stable and within a certain range until the options’ expiration. This strategy can be used in scenarios of low volatility, where you believe the price won’t experience large fluctuations. The primary goal is to capitalize on the small price movements around the middle strike price.

When NOT to Use the Long Butterfly Spread:

This strategy is not suitable when you expect significant price movement in the underlying asset. If the stock price moves too far away from the middle strike price, the potential losses can outweigh the potential gains. 

Additionally, if there’s high volatility in the market, your stock could be just as affected. So you don’t only need to avoid a volatile stock, you also need to avoid a volatile market with this strategy.

In summary, the long butterfly spread is a great strategy for profiting from low volatility scenarios. But it’s always important to carefully consider market conditions, price expectations, and potential risks before implementing this or any options strategy.

Have you used the Long Butterfly strategy before? How has it worked for you?  Let me know in the comments below.

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