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  • If the stock price is at or near the center strike price when the position is established, then the forecast must be for unchanged, or neutral, price action.
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  • Long butterfly[ edit ] A long butterfly position will make profit if the future volatility is lower than the implied volatility.
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Ideally, you want the calls with strikes B and C to expire worthless while capturing the intrinsic value of the in-the-money call with strike A. So the risk vs.

Example What Is a Butterfly Spread? A butterfly spread is an options strategy combining bull and bear spreadswith a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration. Key Takeaways There are multiple butterfly spreads, all using four options.

However, the odds of hitting the sweet spot are fairly low. Constructing your butterfly spread with strike B slightly in-the-money or slightly out-of-the-money may make it a bit less expensive to run. This will put a directional bias on the trade.

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If strike B is higher than the stock price, this would be considered a bullish trade. If strike B is below the stock price, it would be a bearish trade.

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Options Guy's Tip Some investors may wish to run this strategy using index options rather than options on individual stocks. When to Run It Typically, investors will use butterfly spreads when anticipating minimal movement on the stock within a specific time frame. Break-even at Expiration There are two break-even points for this play: Strike A plus the net debit paid.

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Strike C minus the net debit paid. The Sweet Spot You want the stock price to be exactly at strike B at expiration.

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Maximum Potential Profit Potential profit is limited to strike B minus strike A minus the net debit paid. Maximum Potential Loss Risk is limited to the net debit paid. Ally Invest Margin Requirement After the trade is paid for, no additional margin is required.

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As Time Goes By For this strategy, time decay is your friend. Ideally, you want all options except the call with strike A to expire worthless with the stock precisely at strike B.

At this price, only the lower striking call expires in the money. The breakeven points can be calculated using the following formulae. In both situations, the butterfly trader suffers maximum loss which is the initial debit taken to enter the trade. Note: While we have covered the use of this strategy with reference to stock options, the butterfly spread is equally applicable using ETF options, index options as well as options on futures.

Implied Volatility After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices. If your forecast was correct and the stock price butterfly options at or around strike B, you want volatility to decrease.

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Your main concern is the two options you sold at strike B. A decrease in implied volatility will cause those near-the-money options to butterfly options in value, thereby increasing the overall value of the butterfly.

In addition, you want the stock price to remain stable around strike B, and a decrease in implied volatility suggests that may be the case. If your forecast was incorrect and the stock price is approaching or outside of strike Butterfly options or C, in general you want volatility to increase, especially as expiration approaches.

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An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike B, thereby increasing the overall value of the butterfly.