What is Butterfly Options Trading Strategy?
Butterfly Option is a neutral trading option with limited risk and limited profit potential. It is the combination of the various bull and bears spreads. It is used when the trader believes that stocks underlying price will change very little over its lifetime. The butterfly option can be traded either upside or downside.
Components of Butterfly Option
The butterfly options strategy is a three-staged model the body (the middle position shaped as inverted alphabet V)and 2 wings (the 2 opposite spread).
SetUp:
The butterfly spread is in the ratio 1:2:1 and can be constructed using calls(buy) or puts (sell).
- Buy 1 ITM (in the money) Call
- Sell 2 ATM (at the money) Calls
- Buy 1 OTM (Out of the money) Call
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Long Call Butterfly
It should be used when the investor is neutral on market direction and bearish on volatility.
Risk: net debit paid.
Reward: the difference between adjacent strikes minus the net debit
Break-even point:
- 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
Short Call Butterfly
It should be used when you are neutral on market direction and bullish on volatility.
Risk: Limited to the difference between the adjacent risk and the premium that will be received in that position.
Reward: Limited to the net premium received for the option spread.
Break-even point:
- Upper breakeven point =strike price of highest strike short call – net premium received
- Lower breakeven point =strike price of lowest strike short call + net premium received
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Implementing the Strategy:
Take the example of TATA MOTORS. In the last one month, the stock prices of TATA MOTORS are moving in the range 67.60 to 90.55 with the lowest price being 67.25
In this scenario, an investor writes two call options at a strike price of 83.55 and also at 80.90 and 89.05.
In this scenario, an investor would make the maximum profit if TATA MOTORS stock is priced at 83.55 at expiration. If TATA MOTORS is below 80.90 at expiration, or above 89.05, the investor would realize their maximum loss, will be the cost of buying the two wing call options i.e. the higher and the lower strike reduced by the proceeds of selling the two middle strike options.
If the underlying asset is priced between 80.90 and 89.05, a loss or profit may occur. The premium amount paid is 2.50. Thus, if the price of TATA MOTORS is below 81.05(83.55 -2.50) or 86.05(83.55 + 2.50), there will be a loss at expiration. There will be a profit if the stocks are priced between 81.05 and 86.05 at the time of expiry.
Author: Trushali Hindocha
About the Author:
Trushali completed her graduation in Computer science and engineering, she has worked as Associate Consultant in Atos Syntel for 18 months. She is currently pursuing MMS in Finance from KJ Somaiya Institute of Management Studies and Research, Mumbai. She is also well acquainted with Tableau and programming languages like Python and R for Data Analytics.
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