Long butterfly spread stock option trading strategy

What is a butterfly spread?

The long butterfly spread, stock option trading strategy, might be considered by a trader or investor who is either bullish, bearish or neutral regarding their expectations of the movement of the underlying stock.

The butterfly spread can be initiated with either calls or puts and is essentially a four legged option strategy.

The butterfly is popular because of its risk to reward ratio. For limited capital outlay, not only is a maximum loss established, but the maximum profit is much larger than the risk associated with initiating the trade.

A long butterfly option position could consist of purchasing one in the money option contract while simultaneously selling two at the money options and purchasing an out of the money option contract as well.

This may seem like a lot going on, but when you consider the individual legs of the strategy, it makes perfect sense. The two short at the money options not only offset the cost of the long option positions(also known as the wings.) but long options act as your protection from the short at the money option contracts. Without those long positions in place, you would essentially be short two uncovered options, which would considerably change the risk profile of the strategy. In fact, it would be fair to say that without the wings, you would be short a straddle (if short a put and a call).

Keep in mind that the butterfly option position can also be implemented all four legs of the strategy in, as well as out of the money. Although the out of the money butterfly option position has the potential to explode in profits, consideration must always be given to proper risk management to not only stay in the game, but also to prevent needlessly just throwing good money into the wind.

~Good luck, happy trading and remember, a fundamental difference between trading and gambling is that there is no risk management in gambling. Dont gamble with the market. Its a better poker player than you or I will ever be. Risk management is worth its weight in gold. All the best.

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