## Definition

The term butterfly spread refers to a neutral strategy involving a combination of bull and bear spreads using three strike prices.  Butterfly spreads are considered a limited profit, limited risk option strategy.

### Explanation

A butterfly spread is an option strategy consisting of three different strike prices using a combination of puts or calls.  The strategy offers the investor both limited risk as well as reward.  Generally, butterfly spreads take the following two forms:

• Long Butterfly Call:  consists of buying one in-the-money call at the lowest strike price, buying one out-of-the-money call at the highest strike price, and writing two at-the-money calls with a strike price that falls in between.
• Long Butterfly Put:  consists of buying one out-of-the-money put at the lowest strike price, buying one in-the-money put at the highest strike price, and writing two at-the-money puts with a strike price that falls in between.

In both of the above scenarios, a net debit is taken by the investor when entering into the trade.  This net debit (plus commission) is the maximum loss for a long butterfly spread.  The maximum profit for a long butterfly spread occurs when the underlying security's price remains unchanged at expiration.

There are two breakeven points with a butterfly spread, regardless if it is constructed as a put or call:

• Upper Breakeven Point: Strike Price of Highest Strike Price Option - Net Debit Taken
• Lower Breakeven Point: Strike Price of Lowest Strike Price Option + Net Debit Taken

### Example

Company ABC's common stock is trading at \$20.00 per share in January.  A trader enters into a long butterfly call, expiring in one month by purchasing a 15 FEB call for \$550, writing two 20 FEB calls for \$200 each, and buying a 25 FEB call for \$50.  The initial cash outflow for the trader is:

= -\$550 + \$200 x 2 - \$50
= -\$550 + \$400 - \$50, or \$200

Assuming the price of Company ABC's stock remains at \$20.00 at expiration, the trader would realize their maximum profit, calculated as:

= \$500 (value of in-the-money 15 FEB call) - \$200 (initial cash outflow, or debit)
= \$300