Butterfly Spread
A butterfly spread is a limited risk, neutral options trading strategy. Butterfly spread uses four options contracts with the same expiration but with three different strike prices. It can be constructed using either puts or calls.
Example
Buy 1 ITM call (Lower Strike)
Sell 2 ATM calls
Buy 1 OTM call (Higher Strike)
Example
Suppose XYZ stock is trading at $50 and the contract lot size is 100. A trader enters a long call butterfly by purchasing a call at strike $40 for $1100, writing two ATM calls at $50 for $400 each and purchasing another call at $60 for $100. The net debit taken to enter these positions is $400.
Case 1
At expiration, if the XYZ stock is still trading at $50. The ATM calls and OTM call expire worthless while the call at the strike of $40 still has an intrinsic value of $1000. Subtracting the initial debit of $400, the resulting profit is $600, which is also his maximum profit.
Case 2
When the stock is trading below $40, all the options expires worthless and loss occurs which is the initial debt taken. When the stock is trading above $60, any profit from the two long calls will be neutralized by the loss from the two short calls. In both situations, the butterfly trader suffers loss which is the initial debit of $400 taken to enter the trade. This is the maximum possible loss that one can incur in the strategy.