![payoff vs profit diagram payoff vs profit diagram](http://www.optionstar.com/art/art2xp12.gif)
Next, look at the math behind the risk and reward of the strategy. Keep the trade as cheap as possible to avoid tying up too much capital and to minimize potential losses.
![payoff vs profit diagram payoff vs profit diagram](https://www.personalfinancelab.com/wp-content/uploads/floor.png)
Overall, the strategy has a neutral assumption, meaning the investor expects the price of the underlying stock to remain fairly close to its current price.Īlso, investors typically use butterfly spreads in high implied-volatility environments, which makes butterflies cheaper. This leads to paying a debit when opening the trade, which will affect max profit. Because losses will be minimized, it will be cheaper to execute.īut exactly how does this strategy work? And what’s the right environment for the butterfly spread?Īn investor who speculates that a stock won’t move very much from its current price can create a butterfly spread by buying one in-the-money option (ITM), selling two at-the-money options (ATM) and buying one out-of-the-money option (OTM). Even when the butterfly loses money, it typically doesn’t lose big. For that reason, traders can use the strategy when they’re feeling speculative. That means there’s a low probability of profit but also a low probability of large losses. The long butterfly provides a potential alternative.Ī butterfly spread has low probability and low risk. While short straddles and strangles are great trades when investors want to speculate that a stock will not move much, the risk can seem too great. What’s the right environment for the butterfly spread?