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A Short Butterfly is a multi-legged option strategy consisting of all calls or all puts. There are two long options at the middle strike with one short option at a higher strike and one short option at a lower strike. The interval between the higher strike and middle strike is equal to the interval between the middle strike and lower strike. Expirations for each strike are the same. This trade results in a net premium received (credit) upon initial order entry.
Uses The option trader who uses this strategy expects volatility and believes the underlying security will close above or below the outside short strikes by expiration. Risks This strategy is considered to have limited risk and limited reward. The maximum loss occurs when the stock price closes at the long middle strike price by expiration. The maximum loss amount is calculated by taking the interval (high strike to middle strike or middle strike to low strike) and subtracting the premium received upon initial order entry. The maximum gain occurs when the stock price falls below the lower strike or rises above the higher strike by expiration. Maximum gain is equal to the premium received upon order entry. Neutral price activity on the underlying security causing the price to remain at or around the middle strike will have a negative impact on this strategy. Decreasing implied volatility can have a slightly negative impact on this strategy. Option traders electing to close the position before expiration could be impacted by decreasing implied volatility. Time decay impact on this strategy can vary depending on where the price of the underlying security is in relation to the short middle strike. The closer the current price of the underlying security to the short middle strike, the more unfavorably time decay may impact the strategy. Options traders have assignment and exercise risk on this trade. Early assignment (American Style) is a possibility when the short strikes are in-the-money. Also, the option trader runs the risk of uncertainty on assignment when the underlying security is close to one of the short strikes. This situation also results in one of the short strikes still having some time premium on the last day of trading prior to expiration. The option trader should be aware of these risks prior to implementing this strategy.
Important Note: Options involve risk and are not suitable for all investors. For more information, please read the Characteristics and Risks of Standardized Options. |
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