Bulls, Bears and Butterflies

Option spreads is one of the most interesting strategies. It helps one play multiple factors in a go. For instance, if one has initiated a Debit Spread, the play of Delta remains intact while getting protection from diminishing Vega and Theta. Similarly, for a Credit Spread, the Theta gain stays intact, with protection against unfavourable move in Delta or Vega.

Generally, the Spreads are two types based on the cash flow: Credit or Debit. However, from a direction perspective it is either a Bull Spread or Bear Spread. However, if you join the two, it becomes a Butterfly Spread. So, a combination of a Bull & Bear Spread will lead to a Butterfly. 

Let’s understand this a bit more. Infosys is currently quoting around 1060 levels. If I want to initiate a Bull Spread, I can Long 1060 Call and Short a 1100 Call. While, if a wish to initiate a Bear Spread, I can Short 1100 Call and Long 1140 Call. If I combine the two I end up with Butterfly Spread. Here, I am Short 2 X 1100 Calls and Long 1 X 1140 Call and Long 1 X 1060 Call. 

This is more like Netted Butterfly or a Long Butterfly. The benefit would be higher if the stock stays within a range. The Butterfly Spread strategy works best in a non-directional market or when a trader doesn’t expect the security prices to be very volatile in future. That allows the trader to earn a certain amount of profit with limited risk.

Also, it is well protected from adverse movements on either side. The maximum loss is the difference of the cost of buying the Calls adjusted for the inflows The maximum profit is achieved if the price of the underlying at expiration is the same as the written calls. The max profit is equal to the strike of the written option, less the strike of the lower call, premiums, and commissions paid. The only issue here is the transaction cost eats away large part of the gains.

This can be looked at in a slightly different way aswell. Instead of selling two middle strikes you can Long the two middle strikes and short the extreme ends. So, the net position looks like this, Long 2 X 1060 Calls and Short 1 X 1100 Call and Short 1 X 1020 Call. This is like a butterfly in flight or Short Butterfly.

This strategy is established for a net credit, and both the potential profit and maximum risk are limited. The expectation is that the underlying will be volatile. This position maximizes its profit if the price of the underlying is above or the upper strike or below the lower strike at expiry. The maximum profit is equal to the initial premium received, less the price of commissions. The maximum risk is equal to the difference between the lowest and centre strike prices less the net credit received minus commissions. 

Generally, such strategies get built along the way. It may start as a single leg but eventually such a spread gets created. The strategy many a times also works as a repair or a top up to the existing strategies at work.

Happy Trading!!!

Cheers.