The butterfly spread is a neutral strategy that
is a combination of a bull
spread and a bear spread. It is a limited
profit, limited risk options strategy. There are 3 striking prices involved in a butterfly spread and it
can be constructed using calls or puts.
Butterfly Spread Construction
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Buy 1 ITM Call
Sell 2 ATM Calls Buy 1 OTM Call |
Long Call Butterfly
Long butterfly spreads are entered when the
investor thinks that the underlying stock will not rise or fall much by
expiration. Using calls, the long butterfly can be constructed by buying one
lower striking in-the-money
call, writing two at-the-money calls and buying another higher
striking out-of-the-money call.
A resulting net debit is taken to enter the trade.
Limited Profit
Maximum profit for the long butterfly spread is
attained when the underlying stock price remains unchanged at expiration. At
this price, only the lower striking call expires in the money.
The formula for calculating maximum profit is
given below:
- Max Profit
= Strike Price of Short Call - Strike Price of Lower Strike Long Call -
Net Premium Paid - Commissions Paid
- Max Profit
Achieved When Price of Underlying = Strike Price of Short Calls
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Butterfly Spread Payoff Diagram
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Limited Risk
Maximum loss for the long butterfly spread is
limited to the initial debit taken to enter the trade plus commissions.
The formula for calculating maximum loss is given
below:
- Max Loss =
Net Premium Paid + Commissions Paid
- Max Loss
Occurs When Price of Underlying <= Strike Price of Lower Strike Long
Call OR Price of Underlying >= Strike Price of Higher Strike Long Call
Breakeven Point(s)
There are 2 break-even points for the butterfly
spread position. The breakeven points can be calculated using the following
formulae.
- Upper
Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium
Paid
- Lower
Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium
Paid
Example
Suppose XYZ stock is trading at Rs40 in June. An
options trader executes a long call butterfly by purchasing a JUL 30 call for Rs1100,
writing two JUL 40 calls for Rs400 each and purchasing another JUL 50 call for Rs100.
The net debit taken to enter the position is Rs400, which is also his maximum
possible loss.
On expiration in July, XYZ stock is still
trading at Rs40. The JUL 40 calls and the JUL 50 call expire worthless while
the JUL 30 call still has an intrinsic value of Rs1000. Subtracting the initial
debit of Rs400, the resulting profit is Rs600, which is also the maximum profit
attainable.
Maximum loss results when the stock is trading
below Rs30 or above Rs50. At Rs30, all the options expires worthless. Above Rs50,
any "profit" from the two long calls will be neutralised by the
"loss" from the two short calls. In both situations, the butterfly
trader suffers maximum loss which is the initial debit taken to enter the
trade.
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