How does a butterfly spread work and when is it the right trade?

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AcadiFi · Accepted Answer

A long call butterfly has three strikes at 1:2:1 ratio. For Ridgeline Insurance at $100: - Buy 1 $95 call for $6.20 - Sell 2 $100 calls for $3.00 each ($6.00 total) - Buy 1 $105 call for $1.30 - Net debit: $6.20 - $6.00 + $1.30 = $1.50 Payoff at expiration: - Below $95 or above $105: all options expire worthless or offset. Max loss is $1.50 ($150/contract). - At $100 (the middle strike): maximum profit of ($5 - $1.50) = $3.50 per contract. - Between $95 and $100 (or $100 and $105): partial profit that increases as you approach $100. ```mermaid flowchart LR A[Ridgeline at $100] --> B[Buy $95 call] A --> C[Sell 2 $100 calls] A --> D[Buy $105 call] B --> E[Max profit $3.50
at $100] ``` The butterfly is a low-probability, high-reward pin trade. Risk-to-reward is roughly 2.3:1, but the probability of landing exactly at $100 is small. It's effectively a bet on minimal movement combined with short gamma. CFA framing: butterflies are short vega, positive theta near the body, but negative theta in the wings. They shine in low-volatility regimes on stocks with historical pinning behavior around strike prices (often large-cap mega-caps near option-expiration Fridays).

How does a butterfly spread work and when is it the right trade?

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