Short Call Butterfly

 

Description         

 

The Short Call Butterfly is another volatility strategy and is the opposite of a Long Call Butterfly, which is a rangebound strategy. The reason that short butterflies are not particularly popular is because even though they produce a net credit, they offer very small returns compared to straddles and strangles with only slightly less

risk.

            

The Short Call Butterfly involves a low strike short call, two ATM long calls, and an out-of-the-money short call. The resulting position is profitable in the event of a big move by the stock. The problem is that the reward is seriously capped and is typically dwarfed by the potential risk if the stock fails to move.

 

Market Opinion

 

Direction neutral.

 

P/L

 

 

 

 

 

 

When To Use

 

Use this strategy when you anticipate a stock moving with increasing volatility, in either direction, for a capital gain.

 

Example

 

XXXX is trading at $50 on May 14, 2011.

Sell August 2011 45 strike call for $7.98.

Buy two August 2011 50 strike calls at $5.28.

Sell August 2011 55 strike call for $3.35.

 

Net Credit: premiums sold minus premiums bought = $0.77

 

Benefit

 

The benefit is that, with no capital outlay, you can profit from a rangebound stock with capped risk and the possibility of big profit if the stock moves aggressively.

 

Risk vs. Reward

 

The risk is the difference between adjacent strikes minus the net credit. The reward is the net credit you received.

 

Net Upside

 

Net credit received.

 

Net Downside

 

Difference between adjacent strikes minus net credit.

 

Break Even Point

 

Break even up: higher strike minus net credit.

 

Break even down: lower strike plus net credit.

 

Effect Of Volatility

 

Volatility is positive for this position, unless the stock moves outside the outer strikes.

 

Effect Of Time Decay

 

Negative. It harms the position since you are looking for a lot of movement in the stock price.

 

Alternatives Before Expiration

 

To stem a loss, you can close out your position before expiration.

 

Alternatives After Expiration

 

Close out the spread by selling the options you bought and buying back the options you sold.