--%>

Explain Butterfly Spread Strategies

Butterfly Spread Strategies: In this strategy, there is no limit on the number of options that can be combined to form the butterfly spread. This strategy essentially combines both the bear spread and the bull spread. In this case, options with three different exercise prices are used – K1, K2 and K3. Through the use of calls only, the trader would hold a long position in calls with strike prices K1 and K3 while short two calls that have the exercise price of K2 each. It is also assumed that the exercise prices are equally spaced. Thus the value of the option at expiration can be expressed as:

Value = max (0, ST – K1) – 2 * max (0, ST – K2) + max (0, ST – K3).

The initial outflow in the form of option premiums would be c1 – 2 * c2 + c3. This value would always be positive since the lower exercise price of the call option bought (K1) would be lower than the lower exercise of the bull spread sold (K2). The profit which would result from this arrangement is given by:

Profit = max (0, ST – K1) – 2 * max (0, ST – K2) + max (0, ST – K3) – c1 + 2c2 – c3.

If the price at expiration is between the ranges of K1 and K3, there is a net loss as the loss on the two short calls exceeds the gain from the long call (at the lowest exercise price of K1). This strategy that has been described works in situations when it is expected that the aggregate volatility of the market would be relatively low. If the trader expects that the markets would be highly volatile, then it would be better to short the butterfly spread. The payoff diagram along with the values and profits in different scenarios has been represented in the following graph:

1946_butterfly.jpg

It can be seen from the above graph that the long butterfly spread strategy profits only when the volatility of the prices is low. The losses as well as the gains are both limited. The maximum loss is capped at the total premium outflow which occurs at the onset while the maximum profit occurs when the stock’s price at expiration is precisely equal to the middle exercise price. At this price, both the short calls as well as the long call with the highest exercise price exercise worthless while the gain accrues from the call option which has the lowest exercise price.

Alternatively, a butterfly strategy can also be constructed using put options. In this case, if the investor believes that the volatility of the market would be low, then a long position in the spread would have to be taken which implies buying the puts with the exercise prices of K1 and K3, while selling the put options which have the exercise price of K2.

   Related Questions in Corporate Finance

  • Q : Calculate the risk-free rate You have

    You have been given the following information on two corporations; you are to assume that thesecurities are correctly priced. My Corp, Inc. has a Beta of 1.25 and an Expected Return of .145;Your Corp, Inc. has a Beta of .75 and an Expected Return of .095. Based on the

  • Q : Profitability Ratios Profitability

    Profitability Ratios: These ratios comprise the Gross profit Margin, Net profit Margin, Operating Margin, Return on Equity (ROE), and Return on Total Assets. Such ratios help the firm to examine its profitability, the trend in profits and aid to take

  • Q : Who described option pricing with

    Who described option pricing with deterministic volatility?

  • Q : State Transition Management Transition

    Transition Management: It is a financial service accessible to institutional investors who require making significant modifications to their portfolios, like merging, selling, or substantially restructuring them. This procedure can expose investors to

  • Q : Finance You expect KT industries (KTI)

    You expect KT industries (KTI) will have earnings per share of $3 this year and expect that they will pay out $1.50 of these earnings to shareholders in the form of a dividend. KTI's return on new investments is 15% and their equity cost of capital is 12%. The value of a share of KTI's stock is clos

  • Q : Why is Split useful Why is Split useful?

    Why is Split useful?

  • Q : What is the Free Cash Flow Is the Free

    Is the Free Cash Flow (FCF) the sum of the debt cash flow and the equity cash flow?

  • Q : Problem on annual lease payments Taurus

    Taurus Corporation needs a computer, which it can buy for $100,000. Taurus will depreciate the computer uniformly over its useful life of 5 years. An investment tax credit of 7% is also available, and the computer will have no residual value. Taurus plans to borrow th

  • Q : Is the market risk premium a parameter

    Is the market risk premium a parameter, for the world economy or for the national economy?

  • Q : What is the expected risk premium on

    You have decided to invest 30 percent in X; 30 percent in Y; and 40 percent in Z. Theprobability of the state of the economy is Boom 25%; Normal 60%; and, Bust 15%. The rateof return for stock X is Boom .20; Normal .15; and, Bust .00. The rate of return for stock Y is