Basically, this strategy combines a bull spread and a bear spread to form its design.

For
investors to profit from butterfly spreads, the stock price of the underlying assets needs
to be relatively stable. Large movements away from the middle exercise price result in
losses for the investment.

Below, the profit potentials for a bull and bear spread are graphed. The bull spread was
created by purchasing a call with a $35 strike price for $250 and selling a call with a $40
strike price for $175. Although it was not covered in a previous article introducing bear
spreads, they can be created using calls rather than puts.

The bear spread below consists of a long call with a $45 strike and a short call with a
$40 exercise price. Notice that the bear and bull spreads have opposite payoff potential.
The bear spread is essentially a short bull spread.

By combining the bull and bear spread, the profit potential for a butterfly spread can be
shown. In the example below, an investor would purchase two call options, one with a
strike of $35 and one with a strike of $40, and sell two call options with strikes of $40.
The spread exists between the $35 and $45 prices. As the stock price approaches the
$40 point from either end, the butterfly spread gains value. At this $40 point, the
investor using this strategy would realize the maximum profit of $450.

However, because this strategy uses four different call options with different strike
prices, each of the premiums have different prices. This results in potential losses for the
butterfly spread if the stock price deviates far enough away from the $40 point.
Moreover, two break even points exist at the $35.50 and $44.50 points.

As long as the stock price stays between these two prices, the strategy will avoid any
loss. However, once the stock price moves away from this spread, the investor will be
out-of-the-money $50.
Gregory Steffens is a talented writer with a strong interest in business strategy and
strategic management. He is currently completing his MBA degree, with an emphasis in
finance, at the University of Missouri.