--%>

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 : NPV and Other Investment Criteria The

    The XYZ Manufacturing Company is considering the below investment proposal. The initial investment is $100,000. It was an expected economic life of 10 years. The net cash flow in the initial year is expected to be $25,000 and annual net cash flow is expected to develo

  • Q : Expected return for a portfolio What is

    What is the expected return for a portfolio consisting of 200 shares of Nike, 200 shares of Home Depot, and 400 shares of Intel if their expected returns are 10%, 8% and 12% respectively, and their current prices are $25, $50, and $25 per share respec

  • Q : What is the Capital Cash Flow What is

    What is the Capital Cash Flow?

  • Q : Difference between capitalization and

    Is the difference for the value creation in a company among the market value of the shares (capitalization) and their book value a good measure since its foundation?

  • Q : Determining Profitable purchasing ABC

    ABC Corporation is interested in purchasing a machine which will cost $50,000, and it will depreciate it on the straight-line basis over a 5-year period. The machine is predicted to last for 7 years and then Milan will sell it for $5,000. The expected earnings before

  • Q : Who were the creators of uncertain

    Who were the creators of uncertain volatility model?

  • Q : Regarding WACC Regarding the WACC which

    Regarding the WACC which has to be applied to a project, must it be an expected return, the average historical return or an opportunity cost on similar projects?

  • Q : Probability of dividend Universal

    Universal Corporation has the following dividend policy: if the earnings after taxes are less than $1 million, the dividend payout ratio will be 35%, but if these earnings are over $1 million, the dividend payout ratio will be 45%. The EBIT of Universal for next year

  • Q : Price per share for Corporation For XYZ

    For XYZ Corporation debt-to-equity ratio, marginal tax rate, and dividend payout ratio are all of 40%. The cost of debt is 10%. Cambria contains 1 million shares of common stock, and $25 million in long-term bonds. Its dividend is $1 per share. Determine the EBIT and

  • Q : State Exploitation of favorable market

    Exploitation of favorable market conditions: The firms after estimating WCR are in a position to clearly identify their status of excess current assets. After this realization they can use this knowledge to encash conditions arising in market even for