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In finance, a butterfly is a limited risk, non-directional options strategy that is designed to have a large probability of earning a limited profit when the future volatility of the underlying asset is expected to be lower than the implied volatility.
A long butterfly position will make profit if the future volatility is lower than the implied volatility.
A long butterfly options strategy consists of the following options:
where X = the spot price (i.e. current market price of underlying) and a > 0.
Using put–call parity a long butterfly can also be created as follows:
where X = the spot price and a > 0.
All the options have the same expiration date.
At expiration the value (but not the profit) of the butterfly will be:
The maximum value occurs at X (see diagram).
A short butterfly position will make profit if the future volatility is higher than the implied volatility.
A short butterfly options strategy consists of the same options as a long butterfly. However all the long option positions are short and all the short option positions are long.
The double option position in the middle is called the body, while the two other positions are called the wings.
The option strategy where the middle two positions have different strike price is known as an Iron condor.
In an unbalanced butterfly the variable "a" has two different values.