Short Butterfly Spread Explained



Short Butterfly trading strategies are suitable for advanced traders. This involves selling 1 in the money call option, selling 1 out of the money call option, and buying 2 more at the money call options. This does sound a little confusing, but it is basically the same as a bear and bull call spread combined into one.

Sell 1 In The Money (ITM) Call Option
Sell 1 Out of The Money (OTM) Call Option
Buy 2 At The Money (ATM) Call Options

Maximum Profit

The Maximum profit for a short butterfly spread is accomplished when the stock price changes significantly before the expiry date. This means that the lower striking call will expire in the money.

Maximum Loss

The maximum losses a trader can get as a result of a short butterfly spread is limited to the initial premiums paid plus any commissions paid.

Breakeven

If the underlying asset expires above or below the breakeven point, then it is profitable. There are two break even points in a short butterfly spread.

These can be calculated with the following formulas:

Upper Breakeven Point = Strike Price of Highest Strike Short Call – Net Premium Received

Lower Breakeven Point = Strike Price of Lowest Strike Short Call + Net Premium Received

Example

If IBM stocks are currently trading at $40 and you believe that the outlook is bleak, then you could decide to execute a short call butterfly. To do this you would write a May 30 call for $1100, buy two May 40 calls for $400 each and writing a May 50 call for $100. To enter into this position you will need to pay $400 and this is also the maximum profit which could be made from the trade.

If the stock had dropped to $30 on the expiry date of the options then the options will be worthless. This means that you can keep the initial $400 credit as a profit. This is the maximum amount of profit you can earn. You would expect similar profits if the stock was above $50.

If the price of IBM stocks were more stable and it stayed at $40, then the trader would experience the maximum loss. This would mean that all options except for the lower striking call would expire worthless. In this case, the lower striking call sold short would need to be bought back for a value of $1000. When you subtract the initial credit of $400 from this it means that the maximum loss would be $600.

Commission

Earlier we pointed out that commission will also be charged by the broker. To make these examples as easy to understand as possible we have purposely excluded commission payments. The commission is typically around $10-$20 depending on the broker.

This may not sound that much, however, bear in mind that you will need 4 separate contracts for this strategy. This means that the commissions you pay can quickly become much larger. You can find some brokers which specialize in these types of trades and offer discounted rates for frequent traders.

Options House is a great broker to use for this type of trading strategy. This is because they are currently offering trades from $0.15 per contract.

Conclusion

Short Butterfly spread strategies are complex and difficult to understand. You should not really use these when you are starting investing in stocks and options. They are only really suitable for advanced traders with a lot of experience. You need plenty of money for the commission and deposit.

Once you are more experience at investing then you should find that it is actually possible to employ these types of trading strategies successfully.




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