A long butterfly spread is a neutral strategy created by combining both a bull and bear spread. It’s generally considered a low probability but high reward trade.
MAXIMUM PROFIT
The max profit potential is equal to the width of the short and long strike minus the total cost of the trade. The full max profit only being able to be realized if held through expiration and the stock stays exactly at the short strikes.
MAXIMUM LOSS
The maximum loss potential is simply the total cost of the trade. It is realized if the stock price is above or below your two long options. However, as there is assignment risk if held through expiration, so generally recommended to close the spread prior to expiration.
BUTTERFLY SPREAD EXAMPLE
SETUP
Buy 1 $95 Strike Put
Sell 2 $100 Strike Puts
Buy 1 $105 Strike Put
In the above example, the max profit would be realized if the stock remained at $100 through expiration. Max loss would be realized if the stock was above the $105 strike or below the $95 at expiration. The max loss would be the total debit paid to put on the butterfly spread.
WHEN TO CLOSE
Generally, most traders will choose to close out a butterfly spread when it reaches anywhere between 25%-50% profit. The reason the profit target is lower than you may typically aim for is due to low probability nature of the nature of the trade. The likelihood of ever getting near max profit on a butterfly spread is incredibly unlikely, so the profit target is generally lower.
