Goal
To profit from a stock price move up or down beyond the highest or lowest strike prices of the position.
Explanation
A short butterfly spread with calls is a three-part strategy that is created by selling one call at a lower strike price, buying two calls with a higher strike price and selling one call with an even higher strike price. All calls have the same expiration date, and the strike prices are equidistant. In the example above, one 95 Call is sold, two 100 Calls are purchased and one 105 Call is sold. This strategy is established for a net credit, and both the potential profit and maximum risk are limited. The maximum profit is equal to the net premium received less commissions, and it is realized if the stock price is above the higher strike price or below the lower strike price at expiration. The maximum risk equals the distance between the strike prices less the net premium received and is incurred if the stock price is equal to the strike price of the short calls on the expiration date.
This is an advanced strategy because the profit potential is small in dollar terms and because "costs" are high. Given that there are three strike prices, there are multiple commissions in addition to three bid-ask spreads when opening the position and again when closing it. As a result, it is essential to open and close the position at "good prices." It is important to ensure the risk/reward ratio including commissions is favorable or acceptable.
Maximum profit
The maximum profit potential is the net credit received less commissions, and there are two possible outcomes in which a profit of this amount is realized. If the stock price is below the lowest strike price at expiration, then all calls expire worthless and the net credit is kept as income. Also, if the stock price is above the highest strike price at expiration, then all calls are in the money and the butterfly spread position has a net value of zero. As a result, the net credit less commissions is kept as income.
Maximum risk
The maximum risk is equal to the difference between the lowest and center strike prices less the net credit received minus commissions, and a loss of this amount is realized if the stock price is equal to the strike price of the short calls (center strike) at expiration.
In the example above, the difference between the lowest and center strike prices is 5.00, and the net credit received is 1.25, not including commissions. The maximum risk, therefore, is 3.75 less commissions.
Breakeven stock price at expiration
There are 2 breakeven points. The lower breakeven point is the stock price equal to the lower strike short call plus the net credit. The upper breakeven point is the stock price equal to the higher strike short call minus the net credit.
Profit/Loss diagram and table: short butterfly spread with calls
| Sell 1 XYZ 95 call at | 6.40 |
| Buy 2 XYZ 100 calls at 3.30 each | (6.60) |
| Sell 1 XYZ 105 call at | 1.45 |
| Net credit = | 1.25 |
Appropriate market forecast
A short butterfly spread with calls realizes its maximum profit if the stock price is above the highest strike or below the lowest strike on the expiration date. The forecast, therefore, must be for "high volatility," i.e., a price move outside the range of the strike prices of the butterfly.
Strategy discussion
A short butterfly spread with calls is the strategy of choice when the forecast is for a stock price move outside the range of the highest and lowest strike prices. Unlike a long straddle or long strangle, however, the profit potential of a short butterfly spread is limited. Also, the commissions for a butterfly spread are higher than for a straddle or strangle. The tradeoff is that a short butterfly spread has breakeven points much closer to the current stock price than a comparable long straddle or long strangle.
Butterfly spreads are sensitive to changes in volatility (see Impact of Change in Volatility). The net price of a butterfly spread falls when volatility rises and rises when volatility falls. Consequently some traders establish a short butterfly spread when they forecast that volatility is "low" and will rise. Since the volatility in option prices typically rises as an earnings announcement date approaches and then falls immediately after the announcement, some traders will sell a butterfly spread seven to ten days before an earnings report and then close the position on the day before the report. Success of this approach to selling butterfly spreads requires that either the volatility in option prices rises or that the stock price rises or falls outside the strike price range. If the stock price remains constant and if implied volatility does not rise, then a loss will be incurred.
Patience and trading discipline are required when trading short butterfly spreads. Patience is required because this strategy profits from stock price movement and/or rising implied volatility, and stock price action can be unsettling as it rises and falls between the lower and upper strike prices as expiration approaches. Trading discipline is required, because, as expiration approaches, "small" changes in the underlying stock price can have a high percentage impact on the price of a butterfly spread. Traders must, therefore, be disciplined in taking partial profits if possible and also in taking "small" losses before the losses become "big."
Impact of stock price change
"Delta" estimates how much a position will change in price as the stock price changes. Long calls have positive deltas, and short calls have negative deltas.
Regardless of time to expiration and regardless of stock price, the net delta of a butterfly spread remains close to zero until one or two days before expiration. If the stock price is below the lowest strike price in a short butterfly spread with calls, then the net delta is slightly negative. If the stock price is above the highest strike price, then the net delta is slightly positive. Overall, a short butterfly spread with calls profits from a stock price rise above the highest strike price or a fall below the lowest strike price.
Impact of change in volatility
Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Long options, therefore, rise in price and make money when volatility rises, and short options rise in price and lose money when volatility rises. When volatility falls, the opposite happens; long options lose money and short options make money. “Vega” is a measure of how much changing volatility affects the net price of a position.
Short butterfly spreads with calls have a positive vega. This means that the price of a short butterfly spread falls when volatility rises (and the spread makes money). When volatility falls, the price of a short butterfly spread rises (and the spread loses money). Short butterfly spreads, therefore, should be established when volatility is "low" and forecast to rise.
Impact of time
The time value portion of an option's total price decreases as expiration approaches. This is known as time erosion. "Theta" is a measure of how much time erosion affects the net price of a position. Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion.
A short butterfly spread with calls has a net negative theta as long as the stock price is in a range between the lowest and highest strike prices. If the stock price moves out of this range, however, the theta becomes positive as expiration approaches.
Risk of early assignment
Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.
While the long calls (center strike price) in a short butterfly spread have no risk of early assignment, the short calls do have such risk. Early assignment of stock options is generally related to dividends. Short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.
If one short call is assigned (most likely the lowest-strike call), then 100 shares of stock are sold short and the long calls (center strike price) and the other short call remain open. If a short stock position is not wanted, it can be closed in one of two ways. First, 100 shares can be purchased in the marketplace. Second, the short 100-share position can be closed by exercising one of the center-strike long calls. Remember, however, that exercising a long call will forfeit the time value of that call. Therefore, it is generally preferable to buy shares to close the short stock position and then sell a long call. This two-part action recovers the time value of the long call. One caveat is commissions. Buying shares to cover the short stock position and then selling the long call is only advantageous if the commissions are less than the time value of the long call.
If both of the short calls are assigned, then 200 shares of stock are sold short and the long calls remain open. Again, if a short stock position is not wanted, it can be closed in one of two ways. Either 200 shares can be purchased in the market place, or both long calls can be exercised. However, as discussed above, since exercising a long call forfeits the time value, it is generally preferable to buy shares to close the short stock position and then sell the long calls. The caveat, as mentioned above, is commissions. Buying shares to cover the short stock position and then selling the long calls is only advantageous if the commissions are less than the time value of the long calls.
Note, however, that whichever method is used, buying stock and selling a long call or exercising a long call, the date of the stock purchase will be one day later than the date of the short sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short option might also trigger a margin call if there is not sufficient account equity to support the stock position created.
Potential position created at expiration
The position at expiration of a short butterfly spread with calls depends on the relationship of the stock price to the strike prices of the spread. If the stock price is below the lowest strike price, then all calls expire worthless, and no position is created.
If the stock price is above the lowest strike and at or below the center strike, then the lowest strike short call is assigned. The result is that 100 shares of stock are sold short and a stock position of short 100 shares is created.
If the stock price is above the center strike and at or below the highest strike, then the lowest-strike short call is assigned and the two center-strike long calls are exercised. The result is that 100 shares are sold and 200 shares are purchased. The net result is a long position of 100 shares.
If the stock price is above the highest strike, then both long calls are exercised and both short calls are assigned. The result is that 200 shares are purchased and 200 shares are sold. The net result is no position, although several stock sell and buy commissions have been incurred.
Other considerations
A short butterfly spread with calls can also be described as the combination of a bear call spread and a bull call spread. The bear call spread is the short lowest-strike call combined with one of the long center-strike calls, and the bull call spread is the other long center-strike call combined with the short highest-strike call.
The term "butterfly" in the strategy name is thought to have originated from the profit-loss diagram. The peak in the middle of the diagram of a long butterfly spread looks vaguely like a the body of a butterfly, and the horizontal lines stretching out above the higher strike and below the lower strike look vaguely like the wings of a butterfly. A short butterfly spread looks vaguely like an upside-down butterfly.
