--%>

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 : Explain influences of financial

    Does financial leverage (i.e. debt) have any influence on the Free Cash Flow, upon the Cash Flow to Shareholders, upon the growth of the company and upon the value of the shares?

  • Q : How you can predict future evolution of

    Could we suppose that, as we cannot predict the future evolution of the value of shares, a good estimation would be to consider this constant during the next five years?

  • Q : Compute betas against local indexes

    Does it make any sense to compute betas against local indexes while a company has a great part of its operations outside such local market? I have two illustrations: BBVA and Santander.

  • Q : Explain usual value of the sales of net

    Does the usual value of the sales and of the net income of Spanish companies have anything to do along with sustainable growth?

  • Q : What is Stock Market Stock Market : To

    Stock Market: To trade company shares (or stock) and derivatives, a stock market or equity market is public entity where these shares and derivatives are sold at agreed price. These are to be listed on a stock exchange in order to trade publicly.

  • Q : How present value of tax shields be

    I have two valuations of the company that we set as an objective. Within one of them, the present value of tax shields (D Kd T) computed using Ku (required return to unlevered equity) and, in one, by using Kd (required return to debt). The second valuation is too high

  • Q : Define Economy Impacts Economy Impacts

    Economy Impacts: An upcoming economy is indicated by rise in stock market, as stock market is primary indicator of a economic strength of a country. Progressing economy results in market boom. Yield of companies’ increases on improving economy,

  • Q : Problem on rules of the International

    RainFlower Trading Limited is a wholesaler of electronic calculators in Hong Kong. It has been importing goods from a Philippine manufacturer for eight years. The Philippine manufacturer had accepted payments in advance in the past. Recently, because of political turm

  • Q : Affect the value of the stock Is the

     Is the value of this stock dependent on how long you plan to hold it? In other words, if your planned holding period were 2 years or 5 years rather than 3 years, would this affect the value of the stock today, P0? Explain your answer.<

  • Q : Attributes of debt securities What are

    What are the Attributes of debt securities?