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Chapter 14

Butterfly Strategy

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Skill Takeaways: What you will learn in this chapter
  • Overview of the Butterfly Strategy and its variants
  • Detailed understanding of Butterfly Spreads
  • Ideal market conditions for deploying the Butterfly Strategy
  • How options Greeks influence the Butterfly Strategy 

Most widely used options trading strategies are neutral in nature, designed to benefit from markets that remain range bound. Interestingly, markets trend in either direction only about 30% of the time. The remaining 70% of the time, they tend to move sideways. One such strategy that thrives in a non-trending environment is the Butterfly Strategy. 

The name "Butterfly" is inspired by its payoff graph, which resembles a butterfly the central peak forming the body and the tapering sides representing the wings. 

What Is a Butterfly Strategy? 

A Butterfly Strategy is a neutral options strategy formed by merging a bull spread with a bear spread. Since both bull and bear spreads carry limited risk and reward, the Butterfly also has well-defined risk and capped profit potential. 

Maximum profit is realized if the underlying remains within a narrow price band until expiry. Structurally, the strategy consists of four options contracts spread across three different strike prices  all calls or all puts. A variation, known as the Iron Fly, uses a combination of both calls and puts. 

The upper and lower strike prices are placed equidistant from the middle (ATM) strike. This central strike selection depends on the trader’s market view. 

Understanding Butterfly Spreads 

A traditional Butterfly Spread is made up of four legs and suits traders with a neutral market outlook. It is constructed by combining: 

  • One In-the-Money (ITM) option 

  • Two At-the-Money (ATM) options 

  • One Out-of-the-Money (OTM) option 

All contracts must be either calls or puts, not mixed. Also, the ITM and OTM strike prices should be equidistant from the ATM. 

Example: 
If Nifty is trading at 17,500, and the ITM strike is 17,300, the OTM strike should be 17,700. The distance on either side is 200 points. 

Constructing a Butterfly Strategy 

Let’s explore how to build Butterfly Spreads using both calls and puts. 

Call Butterfly 

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The following is a Call Butterfly setup with Nifty at 17512: 

  • Sell 2 ATM Call options (17,500) @ ₹161.60 

  • Buy 1 ITM Call (17,300) @ ₹291 

  • Buy 1 OTM Call (17,700) @ ₹72.95 

Key Metrics: 

  • Max Profit: ₹7,962 (if Nifty closes at 17,500) 

  • Max Loss: ₹2,038 

  • Breakeven Range: 17,341 to 17,659 (range of 318 points) 

  • Margin Required: ₹36,258 

  • Risk-Reward Ratio: ~1:4 

  • Net Cost: ₹2,038 or ₹40.75 [(161.6 x 2) – 291 – 72.95] 

Put Butterfly 

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Using the same strikes for comparison: 

  • Sell 2 ATM Put options (17,500) @ ₹157.95 

  • Buy 1 ITM Put (17,700) @ ₹86 

  • Buy 1 OTM Put (17300) @ ₹268 

Key Metrics: 

  • Max Profit: ₹8,095 

  • Max Loss: ₹1,905 

  • Breakeven Range: 17,339 to 17,661 (range of 322 points) 

  • Margin Required: ₹36,291 

  • Risk-Reward Ratio: ~1:4 

  • Net Cost: ₹1,905 or ₹38.10 [(157.95 x 2) – 86 – 268] 

Iron Fly

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An Iron Fly modifies the Butterfly by selling both an ATM Call and an ATM Put, while buying OTM options on both ends  essentially a Short Straddle with insurance. 

Setup with Nifty at 17,512: 

  • Sell ATM Call (17,550) @ ₹137 

  • Sell ATM Put (17,550) @ ₹181 

  • Buy OTM Call (17,850) @ ₹35 

  • Buy OTM Put (17,250) @ ₹73.90 

Key Metrics: 

  • Max Profit: ₹10,455 

  • Max Loss: ₹4,545 

  • Breakeven Range: 17,341 to 17,759 (range of 418 points) 

  • Margin Required: ₹55,011 

  • Risk-Reward Ratio: ~1:2.3 

When to Create a Butterfly Strategy 

A Butterfly is best deployed when a trader expects the market to remain flat. 

  • Call Butterfly: Ideal for neutral to slightly bearish outlooks. Position the central strike slightly below the current price. 

  • Put Butterfly: Best for neutral to slightly bullish views. Place the middle strike slightly above the current price. 

Maximum profitability is achieved when the underlying closes at or near the middle strike on expiry. 

Strategy Dynamics 

Unlike simpler neutral strategies such as straddles or strangles, the Butterfly involves four legs with a defined risk profile. 

However, because two options are bought for protection, the net profit potential reduces. Hence, it’s a lower reward strategy but comes with tightly controlled risk and low margin requirements. 

Butterflies are most effective when implied volatility is expected to drop, especially after events like earnings announcements or budgets. 

Impact of Greeks on Butterfly Strategy 

Delta 

Delta shows how much the option price will change with a movement in the underlying. A Butterfly’s overall delta depends on the positions and strikes. 

  • Long calls = positive delta 

  • Short calls = negative delta 

  • Long puts = negative delta 

  • Short puts = positive delta 

If the underlying is below the lowest strike, the net delta is slightly positive in a Call Butterfly. Above the highest strike, it turns slightly negative. 

Vega 

Vega measures sensitivity to volatility changes. Since long options gain with rising volatility and short options lose, the net Vega of a Butterfly is negative. 

  • When volatility rises, the strategy loses value. 

  • When volatility drops, it gains value. 

  • Hence, Butterfly strategies work best in high-volatility environments expected to normalize. 

Theta 

Theta indicates time decay in option premiums. 

  • Long options = negative theta 

  • Short options = positive theta 

Since a Butterfly has both, the time decay dynamics depend on positioning and days to expiry. Ideally, the position benefits from time decay if the underlying remains range bound. 

Conclusion 

The Butterfly Strategy offers a balanced, non-directional approach with clearly defined risks and rewards. Whether built using Call or Put options, it serves traders who anticipate a narrow price range. 

The Iron Fly, a variation using both calls and puts, offers a different payoff structure and suits slightly different market views. 

For traders on m.Stock, mastering the Butterfly Strategy adds another powerful tool to navigate sideways markets with minimal capital risk and efficient margin usage. 

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