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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.
Margin requirements for all options positions, including a butterfly, are governed by what is known as Regulation T. However brokers are permitted to apply more stringent margin requirements than the regulations.