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Butterfly Spreads

Recap

Recap

What if?

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Butterfly Spreads

Butterfly Spreads Involves positions in options in three different strike prices:

Buying an option (call or put) with a relatively low strike price (K1)

Buying an option (call or put) with a relatively high strike price (K3)

Selling two options (call or put) with a strike price halfway between the two (K2)

Remember:Call Payoff Formula if ST > K :

Long Call: (Spot Price-Strike Price) - Long Call Premium

Short Call: Short Call Premium - (Spot Price - Strike Price)

Put Payoff Formula if ST < K :

Long Put: (Strike Price-Spot Price) - Long Call Premium

Short Put: Short Call Premium - (Strike Price + Spot Price)

Max profit = K2 – K1 – net investmentMaximum profit is therefore limitedMaximum loss is also limited to the net investment

K1 = $55, call price = $10K2 = $60, call price = $7K3 = $65, call price = $5

Buy 1 call K1 ($10)Buy 1 call K3 ($5)Sell 2 calls K2 $14Investment ($1)

Butterfly Spread Using Call Options

Butterfly Spread Using Put Options

Net Investment of Butterfly Spread (Call) = Net Investment of Butterfly Spread (Put)

Net Investment of Butterfly Spread (Call) = Net Investment of Butterfly Spread (Put)

Why you should consider creating a Butterfly Spread when expecting small movements in the price of the underlying?

Bear Spread vs

Bull Spread vs

Butterfly Spread

Spot = 61Strike Price Call Price

55 1060 765 5

Given:

Bear SpreadLong 65 CallShort 55 Call

Bull SpreadLong 55 CallShort 65 Call

Butterfly SpreadLong 55 Call and 65 CallShort two 60 Call

ComparisonButterfly Returns Outperforms both the Bull and Bear ReturnsDuring periods of small movements in the underlying’s priceButterfly Maximum Loss for making the wrong projection on the market is significantly lower compared to Bull or Bear Maximum Losses

Butterfly Spread = Four

Options= HIGH TRANSACTION COSTS

Disadvantage

HIGH TRANSACTION COSTS

VERY HIGH INVESTMENT= Low Transaction costs

per dollar invested

THE ENDThank you.

Alternate Actions for Butterfly Spreads Before Expiration

1. If the underlying asset has gained in price and is expected to continue rising, you could buy back the short call options and hold the long call options. 

2. If the underlying asset has dropped in price and is expected to continue dropping, you could sell the long call options and hold the short call options. This action is only possible if your broker allows you to sell naked options.