Classic Indicators by Linda Raschke

Options 101: The Butterfly

A butterfly is a spread consisting of 3 legs with exercise prices that are equally spaced apart. All options are either calls or all puts with the same expiration. The ratio is always 1x2x1. In a long butterfly, the outside options are purchased (the wings) and the inside options are sold (the guts). An important characteristic of all butterflies is the limited risk. The cost to put on a long butterfly is the debit which is the max risk. The max gain is the difference between the strike prices minus the debit. The max gain occurs if at expiration the underlying stock price pins to the exercise price of the short calls. If a long butterfly is executed for a credit, the only risk is the execution risk. A large move in the underlying generally hurts, an increase in volatility hurts, and the passage of time helps.