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Butterfly Spread
Butterfly Spread
BYRahul Gupta
The relationship between the underlying and the derivative (e.g. forward, option, swap)
The market in which they trade (e.g., exchange traded or over-thecounter) The type of underlying (e.g. Freight derivatives based on Baltic Exchange shipping indices, equity derivatives, foreign exchange derivatives and credit derivatives)
Options
The right, but not the obligation, to enter into a transaction [buy or sell] at a pre-agreed price, quantity, time [by a specified date in the future], and terms. The option buyer typically pays the seller an upfront fee (the premium) for the option rights.
Options Markets
Over-The-Counter (OTC)
And Physicals Market, Tailored
Exchange Traded
Standardized Terms Style Expiry Dates Strike Levels
All option products & strategies are some combination of buying or selling of calls or puts ..
American Style
Bermudan Style
European Style
Volatility Factor
Measure Of The Degree Of Change In The Value Of The Underlying Asset.
Implied Volatility (Determined Mathematically From Option Pricing Formulas When Premium Is Known ; Reflects Market Perceptions Of Future Volatility)
Spreads
Option spreads are strategies in which the player is simultaneously long and short options of the same type, but with different
Striking prices or Expiration dates
the spreader establishes a known maximum profit or loss potential between either the two strike prices or the two expiration dates or combination thereof Spreads are also known as collars
The spread for an asset is influenced by a number of factors: a) Supply or "float" (the total number of shares outstanding that are available to trade) b) Demand or interest in a stock c) Total trading activity of the stock
TYPES
Price or Vertical spreads Vertical spreads with calls Vertical spreads with puts Calendar spreads Diagonal spreads Butterfly Spread
BUTTERFLY SPREAD An option strategy combining a bull and bear spread. It uses three strike prices. The lower two strike prices are used in the bull spread, and the higher strike price in the bear spread. Both puts and calls can be used.
Bull Spread
An option strategy in which maximum profit is attained if the underlying security rises in price. Either calls or puts can be used. The lower strike price is purchased and the higher strike price is sold. The options have the same expiration date. You make a lot of money if the stock rises. You lose it all if it doesn't. It's one of those higher risk that can cause a lot of anxiety.
Bear Spread
An option strategy seeking maximum profit when the price of the underlying security declines. The strategy involves the simultaneous purchase and sale of options; puts or calls can be used. A higher strike price is purchased and a lower strike price is sold. The options should have the same expiration date. You make money if the underlying goes down and lose if the underlying rises in price.
For call options, one option each at the high and low strike price are bought, and two options at the middle strike price are sold. For put options, the trades are reversed. This strategy is essentially a combination of a bull and bear spread.
NEWS ANNOUNCEMENT S
make sure there are no news announcements or earnings releases due before the expiration of the option.
butterflies are most effective when initiated with expirations between 1 and 2 months out.
Positive Butterfly
A non-parallel yield curve shift in which short- and longterm rates shift upward by a greater magnitude than medium term rates. This yield curve shift effectively humps the curve, adding to its curvature. A non-parallel shift in the yield curve happens when not all of the maturities on the curve move by the same rate. For example, if short-term and long-term rates move upward by 100 basis points (1%) while medium-term rates remain the same, the convexity of the yield curve will increase. This yield curve shift is called a positive butterfly shift because it causes the curve to hump.
Negative Butterfly
A non-parallel yield curve shift in which long- and shortterm yields decrease by a greater degree than intermediate rates. This yield curve shift effectively humps the curve, adding to the curvature of the yield curve. For example, a negative butterfly shift can happen when short- and long term-rates decrease by 75 basis points (0.75%), while intermediate rates only decrease by 50 basis points (0.50%). This is the reverse of a positive butterfly, in which shortand long-term rates increase more than intermediate rates.
Risk = ITM Call premium - ATM Call premium + OTM Call premium.
Profit/Loss at expiration if stock closes between Lower Strike and Middle Strike = Closing Price - Lower Strike - Risk Profit/Loss at expiration if stock closes between Upper Strike and Middle Strike = Higher Strike - Closing Price - Risk
Conclusion
In conclusion, the butterfly spread is a great technique to trade a range bound stock. The key is to buy shorter term premiums and to put the odds in your favor by getting into securities that do not have any news related events during the term of your option. The risk of a butterfly spread is fairly low; however, the reward is as well.
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