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Butterfly Spread
Salient Features
a) Market is expected to remain with in a certain range of prices
b) Unlimited profit and limited loss
Butterfly spread is one of the most important spread trading strategy
used by traders. It involves position in options with three different
strike prices.
It can be created by buying a call option with a lower strike price
X(1), buying a call option with a relatively high strike price X(3), and
selling two call options with a strike price X(2), halfway between X(1)
and X(3).
A butterfly spread leads to profit if the stock price stays close to
X(2),but ends in loss (though it is small) if there is a significant
price movement in either direction.
It is therefore an appropriate strategy for an investor who thinks large price movements are unlikely.
This strategy requires a small initial investment. An example would clear things up.
Nifty closed at 5,703.3 on Friday. Now 5,700 call for October series is quoting at Rs. 107.5, similarly 5,800 call and 5,600 call are quoting at Rs. 171.5 and Rs. 60.6 respectively.
A butterfly spread can be created by buying 5,800 call and 5,600 call and selling two 5,700 call. Total investment is Rs. 17.9 (60.6+171.5- 2*107.1=17.9).
So if the Nifty is trading greater than 5,617 or less than 5,783 then
this strategy is profitable, and if the Nifty is higher than 5,800 or
less than 5,600 then the investor loses his initial investment i.e. Rs. 17.9.
If the Nifty closes in between 5,600-5,617 and 5,783-5,800 range then
the investor recovers some of his/her initial investment but overall it
will be in loss though less than Rs. 17.9.
It has to be noted that we are not including broking charges, inclusion
of broking charges will reduce range at which the Nifty has to close.
The maximum profit from this strategy is Rs. 82.1 when the Nifty closes at 5,700.
Butterfly spreads can also be created using put options. In this case,
the investor buys a put with a low strike price, buys a put with a high
strike price, and sells two puts with an intermediate strike price.
The butterfly spread in the above example would be created by buying a 5,600 and 5,800 put and selling two 5,600 put.
If investors think that there will be volatility than they can short the butterfly spread, by reversing the above positions.
Example 2
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When an investor expects the prices at the time of expiry
of contract to remain close to the current prevailing prices in the market, he
may enter into the Butterfly strategy, which is created by buying two call
options, one with low strike price and the other with comparatively high strike
price, and selling two call options having the strike price which lies in the
middle of above two strike prices and which is close to the current prevailing
market price.
Let us take an example to understand this in detail- an
investor takes following positions on 27th May 2005 when Nifty Spot
was Rs.2070.
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Expecting that the market will remain close to the Spot
Nifty price of Rs.2050 he creates a Butterfly Spread by selling two Nifty Calls
of Rs.2050 and buying two Nifty calls of strike price Rs.2000 and Rs.2100
respectively for which he pays a net amount of Rs.10 as premium {Rs.98 (49*2)
received for shorting two Calls and Rs.84 and Rs.24 paid for two Call options}.
His cash flow at different levels of Nifty closing on 30th
June05 (last Thursday of the following month) are as follows:
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| Thus it is clear from above example that his profits will occur when the Index will close between a certain range (here it is Rs.2020 to Rs.2080) whereas in case of Index closing beyond this range he will make loss. |
