Butterfly Option Strategy in Crypto Trading – What It Is and How It Works

Options trading is one strategy that has been gaining popularity in the crypto trading world. Within this space, the butterfly option strategy stands out as a favorite among both novice and experienced traders. If you’ve heard the term but aren’t quite sure what it entails or how to apply it, you’re in the right place.

This guide will break down everything you need to know about the butterfly option strategy in crypto trading—from the basics of how it works to real-world examples. Whether you're looking to hedge your bets or potentially maximize returns in a volatile market, this strategy can be an effective tool in your crypto trading arsenal.

What is the Butterfly Option Strategy?

At its core, the butterfly option strategy is a neutral options trading approach designed to make a profit when an asset's price is stable or doesn’t move dramatically. It’s a low-risk, limited-reward strategy that can be used when you believe a cryptocurrency’s price will hover around a certain level at expiration (a specific time in the future).

The strategy involves buying and selling multiple options contracts with different strike prices but the same expiration date. In essence, the butterfly strategy creates a "wingspan" of strike prices around a central, target price where you think the asset will settle.

Key Characteristics of the Butterfly Option Strategy

• Market neutral: ideal for low-volatility conditions.
• Limited risk: the maximum loss is known from the start.
• Limited reward: gains are capped, but the risk-to-reward ratio can be attractive in the right market conditions.
• Flexible application: can be used with both call and put options, which are the main types of crypto options. A call option gives the holder (the buyer of the call) the right, but not the obligation, to buy an underlying asset, while the put option gives the holder the right to sell an asset.

Components of a butterfly spread

The butterfly option strategy typically consists of three different legs:

1. Buying 1 lower strike option (out-of-the-money).
2. Selling 2 at-the-money options (where the current price is expected to be).
3. Buying 1 higher strike option (out-of-the-money).

The most common types of butterfly strategies:

• Long call: this is the basic version where you aim for minimal movement in the asset’s price; you expect the price of a cryptocurrency to stay within a narrow range, specifically around a target price. The strategy works well when the crypto market is stable and expected to stay near the at-the-money strike price.
• Short call: this is designed to profit when the price of the cryptocurrency experiences significant volatility and moves outside of a specific range; it’s a more aggressive strategy and comes with higher risk.
• Long put: this is structured with put options instead of calls. This strategy profits when the price of the cryptocurrency remains stable and the options expire around the middle strike price. It's suitable for bearish market conditions or when you anticipate a slight decline.
• Short put: this is the bearish version of the short call butterfly. This strategy profits when the price of the crypto asset moves significantly, either above or below a specific price range. Unlike the long put butterfly, the short put butterfly is riskier and is better suited for periods of expected volatility.
• Iron butterfly: a more advanced version that involves both call and put options, offering more flexibility to form a price-neutral strategy. This means you can profit when the price of a cryptocurrency stays stable around a specific level, just like in a long call butterfly, but with a different structure. The iron butterfly generates a net credit, meaning you collect a premium upfront and aim to profit if the crypto’s price doesn’t move much.
• Reverse iron butterfly: this is the opposite of the iron butterfly, and it aims to profit from high volatility. Instead of benefiting from price stability, the reverse iron butterfly is ideal for traders who expect large price movements.

Example of a Long Call Butterfly
Let’s break down a practical example of a long call butterfly spread using Bitcoin (BTC).

Assume Bitcoin is currently trading at $60,000, and you expect it to stay close to this price until the option's expiration. You could set up the following:

• Buy 1 BTC call option at $78,000 (Lower strike price, OTM).
• Sell 2 BTC call options at $80,000 (At-the-money).
• Buy 1 BTC call option at $82,000 (Higher strike price, OTM).

The costs of the options differ, with out-of-the-money options (those far from the current price) being cheaper than at-the-money options. By combining these legs, you create a “butterfly” where the maximum profit occurs if Bitcoin stays at $30,000, and losses are minimized as the asset moves further away from this strike price.

Advantages of the Butterfly Option Strategy in Crypto Trading

1. Low-risk, defined loss
One of the biggest perks of using a butterfly strategy is the predictability. You know exactly how much you stand to lose from the outset, making it a safer bet than other options strategies. Your maximum loss is limited to the net debit (cost) you paid to set up the position.

2. Works in low volatility markets
When the crypto market enters a phase of low volatility (sideways movement), it can be hard to profit from traditional trading methods like buying and selling directly. Butterfly spreads work best when the price isn’t moving much, allowing you to profit in otherwise boring market conditions.

3. Lower capital requirement
Unlike buying a large position in a cryptocurrency, the butterfly strategy doesn’t require significant capital outlay. You’re only purchasing a small number of options, which means your initial investment is minimal compared to other approaches.

Disadvantages of the Butterfly Option Strategy

1. Limited profit potential
While your losses are capped, so are your profits. If you’re looking for big wins, the butterfly strategy might not be for you. It’s designed for scenarios where the asset stays close to your expected price, and the maximum reward is achieved only at the middle strike price.

2. Requires precise forecasting
To profit from a butterfly spread, the cryptocurrency’s price needs to remain close to the strike price of the options you sold. If the asset moves too much in either direction, you’ll be left with a small gain or even a loss. Timing the market with this level of precision can be tricky, especially in the notoriously volatile crypto space.

When Should You Use a Butterfly Option Strategy?

The butterfly option strategy is ideal for traders who expect minimal price movement or consolidation in a particular cryptocurrency. Let’s say Bitcoin has been ranging between $59,500 and $60,500 for a few weeks. If you believe it will continue trading sideways, a butterfly strategy is a perfect choice.

This strategy can also be used in conjunction with technical indicators. For example, if you spot a Bollinger Bands squeeze or RSI divergence signaling low volatility, it could be a good time to execute a butterfly spread.

Iron Butterfly vs. Long Butterfly

As mentioned earlier, the iron butterfly is a variant of the traditional long butterfly strategy. The key difference lies in how the legs are constructed. In an iron butterfly, you simultaneously use both call and put options.

Example of an Iron Butterfly
Using Ethereum (ETH) as an example, suppose ETH is trading at $1,500, and you expect its price to stay stable:

• Sell 1 ETH call option at $2,500 (ATM).
• Buy 1 ETH call option at $2,550 (OTM).
• Sell 1 ETH put option at $2,500 (ATM).
• Buy 1 ETH put option at $2,450 (OTM).

In this setup, your maximum profit occurs if Ethereum stays at $2,500. The biggest difference here is that you're using both calls and puts, which can offer a wider range of flexibility in volatile markets. It’s a more advanced strategy, so it's recommended for traders with some experience in options trading.

Real-World Application in Crypto Markets

Many professional traders apply the butterfly option strategy during low-volatility periods or when they believe that the price of a crypto asset will stabilize after a period of rapid fluctuation. For instance, in 2022, Bitcoin saw periods of prolonged sideways movement after the significant drops of 2021, presenting prime opportunities for traders to use butterfly spreads effectively.

The Bottom Line

The butterfly option strategy may not be the flashiest trading method in the crypto world, but its simplicity, low risk, and effectiveness in the right market conditions make it a valuable tool for traders. Use this strategy and you’ll potentially profit from a market that’s going nowhere fast—a common scenario in the ever-evolving cryptocurrency landscape.

If you’re looking to add another layer of sophistication to your crypto strategies, the butterfly spread is worth exploring. Just remember that while this strategy reduces your risk, it also caps your rewards, so it’s crucial to apply it in the appropriate market conditions.