--%>

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 : Portfolio return probability XY Company

    XY Company has made a portfolio of such three securities: The correlation coeffic

  • Q : What is Financial Analysis Financial

    Financial Analysis: It is the investigation and interpretation of financial statements and associated financial reports. Trained and certified accountants generally complete this kind of analysis. The role of a financial analyst is to

  • Q : Explain Cost of capital aspect Cost of

    Cost of capital aspect: Estimation of WCR is beneficial from the point of view of cost of capital too. A sound working capital position is beneficial from the point of view of both owners and lenders of the company. A sufficiently positive position me

  • Q : Long-Term Debt What are Long-Term Debt

    What are Long-Term Debt and what are their main parts.

  • Q : What are Stock exchanges Stock

    Stock exchanges: A stock exchange provides services useful for trading, issue and redemption of shares and other securities for traders and brokers. They will also provide facility for payment of income and dividends for listed securities. Securities

  • Q : Explain market efficiency hypothesis

    According to what I read inside a book, market efficiency hypothesis means that the expected average value of variations is zero in the shares price. Thus, the best estimate of the future price of a share is its price now, as this incorporates all the available inform

  • Q : Is this possible to make money in the

    Is this possible to make money in the stock market while the quotations are going down? And what is credit sale?

  • Q : Define Capital Projects Capital

    Capital Projects: It is a long-term investment made in order to build on, add or enhance on a capital-intensive project. A capital project is any undertaking that requires the usage of notable amounts of capital, together with financial and labor, to

  • Q : Is PER an excellent guide to investments

    Is PER an excellent guide to investments?

  • Q : Financing EBIT problem Rusk Inc needs

    Rusk Inc needs $50 million in new capital that it might obtain by selling bonds at par with coupon of 12% or by selling stock at $40 (net) per share. The current capital structure of Rusk consists of $300 million (face value) of 10% coupon bonds selling at 90 and 10 m