Definition
Butterfly Spread
A butterfly spread uses three strikes to bet that the underlying will finish near the middle strike, at low cost and defined risk.
A long call butterfly buys one lower-strike call, sells two middle-strike calls, and buys one higher-strike call. The cost is small, and the maximum profit comes if the underlying expires exactly at the middle strike, tapering off on either side. Risk is limited to the small net premium paid.
Indian traders use butterfly spreads on Nifty and Bank Nifty when they have a precise target level near expiry — for instance pinning to the max pain strike. The low cost and capped risk make it a cheap, high-reward way to express a pin-point view, though the move has to land in a narrow window.
Related terms
- Max PainMax pain is the strike price at which the largest number of option buyers would lose money on expiry.
- Bull Call SpreadA bull call spread buys a lower-strike call and sells a higher-strike call to bet on a moderate rise at lower cost.
- Iron ButterflyAn iron butterfly sells an at-the-money straddle and buys protective wings, for high premium with defined risk.
- Ratio SpreadA ratio spread buys and sells options in unequal numbers, such as buying one call and selling two, to lower cost or add credit.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.