Advanced Strategies for Options - Butterfly Spread

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Advanced Strategies for Options - 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.

3Com Price at Expiration	Profit for 1 March 50 call	Profit for 2 March 60 calls	Profit for 1 March 70 call	Total Profit
40<	($1,200)	$1,200	($300)	($300)
50	($1,200)	$1,200	($300)	($300)
53	($900)	$1,200	($300)	$0
56	($600)	$1,200	($300)	$300
60	($200)	$1,200	($300)	$700
64	$200	$400	($300)	$300
67	$500	($200)	($300)	$0
70	$800	($800)	($300)	($300)
80	$1,800	($2,800)	$700	($300)

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 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.

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