The butterfly spread is an options spread that is geared toward incurring only a limited amount of risk, while having the potential to provide a small amount of profit from the strategy. Essentially, the butterfly spread involves combining a bear spread with a bull spread, and requires following a strict process in order to maximize the chance for making a profit and still manage to limit risk.
The actual process of executing a butterfly spread involves three different strike prices coupled with two lower transactions being part of the bull spread component and two higher transactions arranged in a bear spread. The trades can be arranged in various combinations of puts and calls, depending on the circumstances and the exact configuration that is anticipated to have the best chance of realizing a profit. Most analysts agree that there are four combinations of puts and calls that will result in a butterfly spread.
One basic requirement of the butterfly spread is to arrange the buying and selling so that they involve a range of markets and several different expiration dates. Two of the options should have a higher strike price. Executing the bull and bear spreads to accomplish the butterfly spread is done with the hope that the underlying stock price will remain stable, as this will result in a modest profit from the premium income that is realized on the combination of the options.
While it is important to note that the butterfly spread is designed to be a relatively safe investment tactic, there is some potential for loss. However, if the procedure is followed closely, and the right combination of securities is utilized in the butterfly spread, the chances for creating a small profit are very good. As an investment strategy for persons who tend to be somewhat conservative with investing, but do want to make some attempt to try something a little different, the butterfly spread is an excellent choice.
