BUTTERFLY SPREAD Meaning and
Definition
-
A butterfly spread refers to a popular options trading strategy involving the simultaneous purchase and sale of three options contracts with the same expiration date but different strike prices. This strategy is typically employed when the trader expects the underlying asset to trade within a specific price range.
To construct a butterfly spread, the trader first sells two at-the-money options, usually calls or puts, at a specific strike price. Then, the trader simultaneously purchases one out-of-the-money option with a lower strike price and one out-of-the-money option with a higher strike price. The result is a combination of a vertical credit spread and a vertical debit spread, creating a unique risk/reward profile.
The butterfly spread derives its name from the shape of its risk/reward graph, which resembles the wings of a butterfly. The maximum profit occurs if the underlying asset's price at expiration closely matches the central strike price. Conversely, the maximum loss is limited to the initial debit taken to establish the position.
Traders employ the butterfly spread to take advantage of situations where they predict limited price movement in the underlying asset. By utilizing options with different strike prices, the trader can potentially profit from a narrow range of prices while limiting their potential risk. This strategy is commonly used when traders expect low volatility or when they believe the underlying asset will consolidate.
Etymology of BUTTERFLY SPREAD
The etymology of the phrase "butterfly spread" can be understood by examining the meaning of its individual components.
1. Butterfly: The word "butterfly" is derived from the Old English word "buttorfleoge", which combines "buttor" (butter) and "fleoge" (fly). This name was given to these insects because some species were commonly found around milk churns and were believed to steal butter. Over time, the term evolved into "butterfly".
2. Spread: In the context of financial markets, a "spread" refers to the difference between the bid price (the price a buyer is willing to pay) and the ask price (the price a seller is willing to accept) of a particular financial instrument, such as options or futures contracts.
When combined, the phrase "butterfly spread" describes a specific trading strategy involving options contracts.
Similar spelling word for BUTTERFLY SPREAD
