Butterfly Spreads Involves positions in options in three different strike prices: Buying an option (call or put) with a relatively low strike price (K 1 ) Buying an option (call or put) with a relatively high strike price (K 3 ) Selling two options (call or put) with a strike price halfway between the two (K 2 )
Remember: Call Payoff Formula if S T > K : Long Call: (Spot Price-Strike Price) - Long Call Premium Short Call: Short Call Premium - (Spot Price - Strike Price)
Put Payoff Formula if S T < K : Long Put: (Strike Price-Spot Price) - Long Call Premium Short Put: Short Call Premium - (Strike Price + Spot Price)
Max profit = K2 – K1 – net investment Maximum profit is therefore limited Maximum loss is also limited to the net investment
Butterfly Spread Long 55 Call and 65 Call Short two 60 Call
Comparison Butterfly Returns Outperforms both the Bull and Bear Returns During periods of small movements in the underlying’s price Butterfly 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
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.