The short butterfly is a neutral strategy like the long butterfly but bullish on volatility. It is a limited profit, limited risk options trading strategy. There are 3 striking prices involved in a short butterfly spread and it can be constructed using calls or puts.
|Short Butterfly Construction|
|Sell 1 ITM Call|
Buy 2 ATM Calls
Sell 1 OTM Call
Using calls, the short butterfly can be constructed by writing one lower striking in-the-money call, buying two at-the-money calls and writing another higher striking out-of-the-money call, giving the trader a net credit to enter the position.
Maximum profit for the short butterfly is obtained when the underlying stock price rally pass the higher strike price or drops below the lower strike price at expiration.
If the stock ends up at the lower striking price, all the options expire worthless and the short butterfly trader keeps the initial credit taken when entering the position.
However, if the stock price at expiry is equal to the higher strike price, the higher striking call expires worthless while the "profits" of the two long calls owned is canceled out by the "loss" incurred from shorting the lower striking call. Hence, the maximum profit is still only the initial credit taken.
The formula for calculating maximum profit is given below:
Maximum loss for the short butterfly is incurred when the stock price of the underlying stock remains unchange at expiration. At this price, only the lower striking call which was shorted expires in-the-money. The trader will have to buy back the call at its intrinsic value.
The formula for calculating maximum loss is given below:
There are 2 break-even points for the short butterfly position. The breakeven points can be calculated using the following formulae.
Suppose XYZ stock is trading at $40 in June. An options trader executes a short call butterfly strategy by writing a JUL 30 call for $1100, buying two JUL 40 calls for $400 each and writing another JUL 50 call for $100. The net credit taken to enter the position is $400, which is also his maximum possible profit.
On expiration in July, XYZ stock has dropped to $30. All the options expire worthless and the short butterfly trader gets to keep the entire initial credit taken of $400 as profit. This is also the maximum profit attainable and is also obtained even if the stock had instead rallied to $50 or beyond.
On the downside, should the stock price remains at $40 at expiration, maximum loss will be incurred. At this price, all except the lower striking call expires worthless. The lower striking call sold short would have a value of $1000 and needs to be bought back. Subtracting the initial credit of $400 taken, the net loss (maximum) is equal to $600.
Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the short butterfly as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.
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The following strategies are similar to the short butterfly in that they are also high volatility strategies that have limited profit potential and limited risk.
The converse strategy to the short butterfly is the long butterfly. Long butterfly spreads are used when one perceives the volatility of the price of the underlying stock to be low.
The short butterfly can also be created using puts instead of calls and is known as a short put butterfly.
The short butterfly spread belongs to a family of spreads called wingspreads whose members are named after a myriad of flying creatures.
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