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Advanced Strategies for Options -
Vertical Spreads - Butterfly Spread
Butterfly
Spread Using Calls Only
Now
that we understand some of the more common vertical spreads it is
time to tackle the granddaddy of all exotic spreads; the butterfly
spread
The
butterfly spread is a neutral strategy, that is the best results
are obtained if the underlying stock does not rise or fall
significantly by the expiration date. Profits are limited but they are greater than the potential
risk and for this reason the butterfly spread is very popular
among strategists.
There
are three strike prices involved in a butterfly spread. The butterfly spread consists of buying one call at the
lowest strike price, selling two calls at the middle strike price
and buying one call at the highest strike price.
Why
would anyone want to execute such a transaction? As we will see from the following example if the conditions
are correct the butterfly spread offers attractive rates of return
with relatively small risk.
Allen
has been watching the shares of 3Com (COMS) for a long time and he
notices the shares normally trade in a very narrow range following
the first quarter earnings. With
COMS shares trading at 60 Allen decides to enter the following
strategy. He buys one contract of the COMS March 50 call at a price of
$12 ($1,200), sells two contracts of the COMS March 60 calls for
$6 ($1,200) and buys one contract of the COMS March 70 call for $3
($300). The entire
transaction creates a net debit of $300.
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3Com
Price at Expiration
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Profit
for 1 March 50 call
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Profit
for 2 March 60 calls
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Profit
for 1 March 70 call
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Total
Profit
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40<
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($1,200)
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$1,200
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($300)
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($300)
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50
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($1,200)
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$1,200
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($300)
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($300)
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53
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($900)
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$1,200
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($300)
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$0
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56
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($600)
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$1,200
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($300)
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$300
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60
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($200)
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$1,200
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($300)
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$700
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64
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$200
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$400
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($300)
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$300
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67
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$500
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($200)
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($300)
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$0
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70
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$800
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($800)
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($300)
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($300)
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80
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$1,800
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($2,800)
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$700
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($300)
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As
we can see from the table above the maximum profit is realized at
the strike price of the written calls. This makes sense because if the stock were to reach $60 by
expiration both written calls would expire worthless for a total
profit of $1,200. We can also see that risk is limited both to the upside and
to the downside and in both cases the potential loss is limited to
the net debit. In
this case the maximum loss is $300. The “sweet spot” is between $53 and $67. If the stock closes at expiration within this range, the
spread will be profitable.
There
is one final factor associated with butterfly spreads. The collateral investment required for a butterfly spread
is not simply the net debit. Since the spreads consist of both a bull and bear spread
the collateral requirement is the sum of the requirements for both
spreads. In our
example the bull spread (buying the March 50 calls and selling the
March 60 call) creates a net debit of $600. The bear spread (selling the March 60 call and buying March
70 call) has a margin requirement of $700. This margin requirement is the difference between the
strike prices ($10) plus the $3 paid for the March 70 calls less
the $6 received for the sale of March 60 calls.
It
also apparent that the most attractive butterfly spreads are those
with very small net debits since this is the maximum potential
loss. It also makes
sense for investors to establish butterfly spreads with the middle
strike price near the current common stock price (at-the-money).
Summary
1. The net collateral investment is the distance
between strike prices plus the net debit.
2. The maximum profit is the distance between strike
prices less the net debit.
3. The downside break-even point is the lowest strike
plus the net debit.
4. The upside break-even point is the highest strike
price less the net debit.
5. Butterfly spreads offer both limited upside and
downside risk.
6. Butterfly spreads offer limited profit potential.
7. Butterfly spreads can be an attractive strategy but
investors should remember each transaction involves a commission
that may substantially lessen returns.
More
Fun with Butterfly Spreads
By
now you should know that any strategy constructed with call
options can also be constructed with put options. This means an investor can establish a butterfly spread
with puts by buying one put at the lowest strike price, selling
two puts at the middle strike price and selling one put at the
highest strike price. That
is pretty straightforward.
Another
way to establish a butterfly spread is considerably more
complicated. We know
that a butterfly spread is simply the combination of a bull spread
and a bear spread. However, there is more than one way to establish bull and
bear spreads. You can
imagine how complicated this gets.
The
third butterfly spread involves the purchase of one put at the
lowest strike price, the sale of one put at the middle strike
price, the sale of one call at the middle strike price and the
purchase of one put at the highest strike price. Is your head hurting yet?
We’re not going to run through an example of
this butterfly spread but suffice to say it is a legitimate way to
establish the position.
reverse
ratio spread 
neutral
calendar spread
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Home > Education > Using Options > Advanced Strategies >
Vertical
Spreads > Butterfly Spread
