WHAT IS BUTTERFLY SPREAD CALLS STRATEGIES?

 

Understanding butterfly spread call strategies

 

   The butterfly spread is a popular options trading strategy used by traders to take advantage of low volatility in the underlying asset. It is widely regarded for being a limited-risk, limited-reward strategy, meaning that both the potential profit and the potential loss are capped. The butterfly spread can be executed using either call options or put options, but in this discussion, we’ll focus on the butterfly spread with calls.

 

What Is a Butterfly Spread with Calls?

 

   A butterfly spread with calls is a neutral options strategy involving three strike prices. The strategy is constructed by buying one call option at a lower strike price (let's call it Strike A), selling two call options at a middle strike price (Strike B), and buying one more call option at a higher strike price (Strike C). The result is a net debit (or cost) to the trader because the cost of the two options bought exceeds the premium collected from selling the two middle-strike call options.

 

   The butterfly spread is designed to profit when the price of the underlying asset remains close to the middle strike price (Strike B) at expiration. If the underlying stock price stays at or near Strike B, the strategy achieves its maximum profit. However, if the price moves significantly away from Strike B in either direction, the trade will result in a loss, though this loss is limited.

 

Components of a butterfly spread with calls

 

To understand the butterfly spread with calls, let’s break it down into its essential components:

 

Buying one lower-strike call option (Strike A):

 

This is a long call option, meaning the trader has the right to buy the underlying asset at Strike A.

This option gives the trader the opportunity to profit if the price of the underlying asset rises above Strike A.

 

Selling two middle-strike call options (Strike B):

 

These are short call options, meaning the trader has the obligation to sell the underlying asset at Strike B if exercised.

Selling these call options generates a premium (income), but limits the trader’s profit potential because any price increase beyond Strike B results in a loss on these sold calls.

 

Buying one higher-strike call option (Strike C):

 

This is another long call option, giving the trader the right to buy the underlying asset at Strike C.

This option limits the potential loss on the short calls sold at Strike B by capping the risk if the asset’s price rises significantly.

Visualizing the Setup

Strike A:  Lower strike price (long call)

Strike B:  Middle strike price (short two calls)

Strike C:  Higher strike price (long call)

The relationship between these strikes is generally equidistant. For example, if Strike B is set at Rs.50, Strike A might be set at Rs.45, and Strike C at Rs.55. This gives the spread a symmetrical profile, which is a characteristic feature of the butterfly strategy.

 

How Does the Butterfly Spread with Calls Work?

 

The butterfly spread with calls profits when the price of the underlying asset is near Strike B at expiration. Here’s how the strategy behaves in different scenarios:

 

At expiration, if the underlying asset’s price is near Strike A (the lower strike):

 

All options expire worthless because the price is below both Strike A and Strike B.

The trader incurs a loss, limited to the initial debit paid to enter the trade (the net premium paid for buying the butterfly).

 

At expiration, if the underlying asset’s price is near Strike B (the middle strike):

 

This is the ideal scenario for a butterfly spread with calls.

The options sold at Strike B are at or near their maximum value, while the options bought at Strike A and Strike C are nearly worthless or only slightly in-the-money.

The trader achieves maximum profit when the asset’s price is exactly at Strike B at expiration, because both sold options will expire worthless, while the bought options will have intrinsic value.

Maximum profit = Difference between Strike A and Strike B minus the net debit paid.

At expiration, if the underlying asset’s price is near Strike C (the higher strike):

 

The long call at Strike A gains value as the asset’s price rises, but this gain is offset by the loss on the two sold calls at Strike B.

If the asset’s price continues rising above Strike C, both the long call at Strike C and the sold calls at Strike B are in-the-money, leading to a limited loss.

However, the maximum loss is limited to the initial cost (net debit) of the trade.

Risk and Reward Profile

 

One of the key benefits of the butterfly spread with calls is its limited risk and limited reward structure. Here’s a breakdown:

 

Maximum profit:  The maximum profit occurs when the underlying asset’s price is exactly equal to Strike B at expiration. The profit is the difference between Strike A and Strike B, minus the net debit paid to establish the trade.

 

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Max Profit=(StrikeB−StrikeA)−NetDebit

 

Maximum loss:  The maximum loss is limited to the initial cost of the trade, which is the net debit paid. This occurs if the price of the underlying asset is significantly below Strike A or above Strike C at expiration.

 

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Breakeven Points: There are two breakeven points for a butterfly spread with calls:

 

The lower breakeven point is calculated as Strike A plus the net debit paid.

The upper breakeven point is calculated as Strike C minus the net debit paid.

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Lower Breakeven=StrikeA+NetDebit

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Upper Breakeven=StrikeC−NetDebit

 

Advantages of a butterfly spread with calls

 

Limited risk:  The maximum loss is known from the outset and is limited to the net debit paid to enter the trade.

Defined reward:  The maximum profit is also capped but can be substantial compared to the cost of the trade if the price of the underlying asset stays near the middle strike price at expiration.

Neutral strategy:  The strategy works best when the trader expects low volatility and the underlying asset price to remain stable.

 

Disadvantages of a butterfly spread with calls

 

Limited reward:  Although the potential profit is defined, it is limited, making the strategy less appealing in high-volatility environments.

Low probability of maximum profit:  The probability of the underlying asset’s price being exactly at Strike B at expiration is relatively low, which means that achieving the maximum profit is challenging.

Time decay:  Since the strategy involves selling options, time decay (theta) works in the trader’s favor when the price is near Strike B but against the trader when the price is far from Strike B.

 

When to Use a Butterfly Spread with Calls?

 

   The butterfly spread with calls is best suited for low-volatility environments, where the trader expects the underlying asset’s price to remain within a narrow range. This strategy is often used around significant market events, such as earnings announcements or economic reports, when the trader believes that the market has overestimated the potential for large price moves.

 

Conclusion

 

   A butterfly spread with calls is an advanced options strategy that offers limited risk and limited reward, making it an attractive choice for traders who anticipate low volatility in the underlying asset. Its symmetrical payoff structure, centered around the middle strike price, provides a clearly defined range of outcomes. However, it requires careful planning and execution, as the potential to achieve the maximum profit is highly dependent on the price of the underlying asset being near the middle strike at expiration.