PRESENTATION ON BUTTERFLY SPREAD

BYPRIYANKA MITTAL NANCY SACHDEV KANIKA SAHWNEY ANUSHREE GOVIL

What are derivatives?

A derivative is a financial instrument that is derived from some other asset, index, event, value or condition (known as the underlying asset). Rather than trade or exchange the underlying asset, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. Derivatives can be used by investors to speculate and to make a profit if the value of the underlying moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). Alternatively, traders can use derivatives to hedge or mitigate risk in the underlying.

Derivatives can be categorised by -

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

Basic Options Structures

Calls Options acquired by a buyer (holder) and granted by a seller (writer) to buy at a fixed price Puts Options acquired by a buyer and granted by a seller to sell at a fixed price

All option products & strategies are some combination of buying or selling of calls or puts ..

Basic Options Provisions

Buy or Sell - Long or Short Call or Put Underlying Asset - Product , Security/ Instrument Strike (Exercise) Price Premium Exercise Date and Style

Basic Options Provisions - Strike

Strike Price Fixed price to be paid if option exercised, as specified in the options agreement; Set in intervals on exchange traded options; At any preferred level OTC.

Basic Options Provisions - Premium

Premium Price of the option that buyer pays and seller receives at the time of option transaction; Consideration paid for rights; Non-Refundable.

Option Exercise Provisions or Style

American Style

Bermudan Style

European Style

Volatility Factor
Measure Of The Degree Of Change In The Value Of The Underlying Asset.

Historical Volatility (Determined From Past Price Data)

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 better understanding. . . . .

An option strategy to sell several call options and at the same time buy several call options on the same security or futures contract. The options have different maturity dates and the exercise price of the options will differ. If the underlying security makes no dramatic moves, the options trader hopes to make a profit by collecting income from the premiums.

 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.

How to find a candidate for a Butterfly?

TRADING RANGE locate range bound stocks(spot a situation in which a volatile stock is getting ready to get range bound) This can often be seen when stocks have tremendous price moves accompanied by a heavy expansion in volume and also by an intraperiod reversal.

NEWS ANNOUNCEMENT S

make sure there are no news announcements or earnings releases due before the expiration of the option.

SELECTING TIME TO EXPIRATION

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.

What is the Butterfly Option Spread?

The butterfly spread is put together to create a low risk, low reward options strategy and is designed to take advantage of a market or stock that is range bound. The butterfly can be created using call or put options. The strategy is termed "butterfly" due to the shape of the risk characteristics graph you see below; notice the two wings and then the larger body. The butterfly spread is constructed through buying 1 long ITM call, shorting 2 ATM calls, and buying 1 long OTM call. The ratio between the 3 options should be 1:2:1 and the distance between the strike prices of the long options should be equidistant from the short call strike. For example, a butterfly spread could be made of 3 call options with strikes of 100, 105, and 110.

Risk = ITM Call premium - ATM Call premium + OTM Call premium.

Butterfly Spread Construction

BUY 1 ITM CALL

SELL 2 ATM CALLS BUY 1 OTM CALL

Example of a butterfly spread .

Let's look at a real life example of a butterfly spread so you can get a better idea of how it works . .We are going to work with an example using Freddie Mac (FRE). The stock has recently spiked down on gigantic volume and this put the base in of the trading range. As mentioned above, the rally following the bottom usually sets up the top of the trading range. Reviewing the graph below, you can see that FRE has setup a range between $25 and $35 and it is currently trading right near the middle of that range, at $29.58.

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

Long Call Butterfly

Long butterfly spreads are entered when the investor thinks that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking in-the-money call, writing two at-the-money calls and buying another higher striking out-of-the-money call. A resulting net debit is taken to enter the trade.

Long Call Butterfly

Long Put Butterfly