The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast - when you expect the underlying stock price or index level to change very little over the life of the options. A butterfly can be implemented using either call or put options.

For simplicity, the following explanation discusses the strategy using call options.

Using the broken-wing butterfly options strategy | Futures Magazine

A long call butterfly spread consists of three legs with a total of four options: All the calls have the same expiration, and the middle strike is halfway between the lower and the higher strikes.

The position is considered "long" because it requires a net cash outlay to initiate. When a butterfly spread is implemented properly, the potential gain is higher than the potential loss, but both the potential gain and loss will be limited.

Butterfly Spread

The total cost of a long butterfly spread is calculated by multiplying the net debit cost of the strategy by the number of shares each contract represents.

A butterfly will break-even at expiration if the price of the underlying is equal to one of two values. The first break-even value is calculated by adding the net debit to the lowest strike price. The second break-even value is calculated by subtracting the net debit from the highest strike price.

The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices.

The maximum risk is limited to the net debit paid for the position. Butterfly spreads achieve their maxim profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration. As with all advanced option strategies, butterfly spreads can be broken down into less complex components.

The long call butterfly spread has two parts, a bull call spread and a bear call spread. The following example, which uses options on the Dow Jones Industrial Average DJX , illustrates this point.

Please note that this is a three-legged trade, and there will be a commission charged for each leg of the trade.

This profit and loss graph allows us to easily see the break-even points, maximum profit and loss potential at expiration in dollar terms.

The calculations are presented below.

The two break-even points occur when the underlying equals On the graph these two points turn out to be where the profit and loss line crosses the x-axis. The maximum profit can only be reached if the DJX is equal to the middle strike 75 on expiration.

The maximum loss, in this example, results if the DJX is below the lower strike 72 or above the higher strike 78 on expiration. By looking at the components of the total position, it is easy to see the two spreads that make up the butterfly.

A long butterfly spread is used by investors who forecast a narrow trading range for the underlying security, and who are not comfortable with the unlimited risk that is involved with being short a straddle. The long butterfly is a strategy that takes advantage of the time premium erosion of an option contract, but still allows the investor to have a limited and known risk.

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Butterfly Spread Explained | Online Option Trading Guide

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Butterfly - Index

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Multiple leg options strategies will involve multiple commissions. Member SIPC "Schwab" and optionsXpress, Inc. Deposit and lending products and services are offered by Charles Schwab Bank, Member FDIC and an Equal Housing Lender "Schwab Bank".

An expiration profit and loss graph for this strategy is displayed below.