A butterfly spread is a neutral position that’s created by combining long and short call or put options, at three different strike prices. This spread is typically created using a ratio of 1-2-1 (1 ITM option, 2 ATM options, 1 OTM option). Investors have the choice to either buy or sell butterfly spreads, but at tastytrade we tend to buy call or put butterfly spreads to take advantage of the non-movement of an underlying stock.
When we trade a butterfly spread, we are placing a bet that the price is going to stay within a relatively tight range. This is a low probability trade, but we use this strategy when implied volatility is high, as the butterfly spread then trades cheaper. The spread trades cheaper in this situation since the price of the ITM option consists primarily of intrinsic value, therefore selling the ATM options covers a higher percentage of the cost of purchasing both of the long options.