Butterfly spreads combine the bull and bear spreads and involve three options wi
ID: 2755635 • Letter: B
Question
Butterfly spreads combine the bull and bear spreads and involve three options with different strike prices and the same expiration date. If the investor expects the price of the stock to be stable (the butterfly will “not flap its wings”), the individual buys the options with the highest and lowest strike prices and sells two options with the strike price in the middle. If the investor expects the price of the stock to fluctuate (i.e., the butterfly will “flap its wings”), the process is reversed. The investor sells the outer options and buys two of the calls with the strike price in the middle. For example, suppose a stock is selling for $61 and there are three-month call options at $57, $60, and $63. The prices of the options are $6, $3, and $1, respectively. a) The investor expects the price of the stock to be stable. What would the investor gain or lose at the options’ expiration from constructing an appropriate butterfly spread at the following prices of the stock: $50, $55, $57,$60, $63, $65, and $70? b) What is the maximum possible loss? c) What is the maximum possible gain? d) What is the range of stock prices that produces a gain from constructing this butterfly? e) Did the butterfly achieve its objective based on the expectation that the price of the stock would be stable?
Explanation / Answer
Butterfly Spread
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.
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 strikingout-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
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
Commissions
Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the butterfly spread as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.
Short Butterfly
The converse strategy to the long butterfly is the short butterfly. Short butterfly spreads are used when high volatility is expected to push the stock price in either direction.
Long Put Butterfly
The long butterfly trading strategy can also be created using puts instead of calls and is known as a long put butterfly.
Wingspreads
The butterfly spread belongs to a family of spreads called wingspreads whose members are named after a myriad of flying creatures.
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