Butterfly spread
There are two types of butterfly spread
1) long butterfly spread
2) short butterfly spread
1) long butterfly spread with calls
Motive of strategy.....
Profit with range or neutral stock price move near the strike price of short calls with limited risk.
Example,
Reliance trading as on 18 Feb is 1220.1 rs.
Applying long butterfly now.....
Buy 1 lot 1200 call @ 41 rs.
Sell 2 lot 1220 call @ 59 rs. (29.5 Each)
Buy 1 lot 1240 call @ 20.15 rs.
Net cost ======== (2.15)
A long butterfly spread with calls is a three part strategy creating by buying lower strike price, selling two calls with a higher strike price and buying one call with even higher strike price, all call have same expiration date, with same gap of strike here gap of 20 rs. To each strike.
Maximum risk.....
The maximum risk is the net cost of the strategy here rs. 2.15
Two outcome possible.....
One stock price expiration below lower strike price then all call will expire out of money, all call will expire worthless and maximum loss will be net cost plus brokerage
Second, stock price expiration above higher strike price then all call will expire in the money, all call will expire at intrinsic value while butterfly spread position has a net value of zero at expiration so net risk will be net debit plus brokarage.
Maximum profit.....
Maximum profit potential is equal to difference of lower strike and middle strike price less net debit paid including brokarage.
Here difference is 20rs.
So 1220-1200 = 20 - 2.15 rs. Is equal to 17.85 rs.
Break even point.....
There are two breakeven point.....
The lower breakeven point is lowest strike price plus cost of the position
The upper breakeven is the stock price equal to highest strike price minus cost of position.
Reliance expiry at 1200 rs.
Then all call with expire out of money so net loss will be cost of position so if reliance expire at 1197.85 rs. Then it is breakeven point.
Same way if stock expire at 1237.85 then.....
Value of 1200 call is 37.85
Value of 1220 call is (35.70)
Value of 1240 call is 0
Net profit is 2.15 rs. Is equal to cost of position.
Strategy useful.....
A long butterfly strategy is used where stock price remain near to middle strike or in range of butterfly we initiated.
Moreover, butterfly is having limited risk with limited profit. In short strangle and short straddle time decay is much higher compare to butterfly but the same time risk is limited to net cost of position.
It is useful during result season where company post inline result as per poll expected then maximum time value will decay at the money option and strategy holder will be benefited much.
Even low beta stock one can do long call butterfly strategy.
Limitation.....
Due to 3 calls position brokerage use to high compare to single call strategy.
2) short call butterfly.....
It is reverse of long calls butterfly here
Reliance stock how we can initiate short call butterfly.....
Selling 1 lot of 1200 call @ 41
Buying 2 lot of 1220 call @ (59)
Selling 1 lot of 1240 call @ 20.15
Net Gain =========== 2.15 rs.
Whatever risk in long call butterfly will be maximum profit for short call butterfly.
And maximum profit in long call butterfly will be maximum loss for short call butterfly.
It is reverse of long calls butterfly only.
Happy reading derivativelearn
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