Long & Short Butterfly Strategy

Purab Kumar -

The butterfly strategy is an options trading strategy that involves the use of four options contracts with the same expiration date but different strike prices. The strategy is designed to take advantage of a relatively stable underlying asset price and involves both long and short positions.

This blog will discuss the long and short butterfly strategy in detail, including its key characteristics, benefits, drawbacks, and some examples.

What is the Butterfly Strategy?

The butterfly strategy is a neutral options trading strategy that seeks to profit from a narrow range of prices for the underlying asset. The strategy is implemented by simultaneously buying and selling four options contracts, as follows:

  1. Buy one call option with a strike price below the current market price of the underlying asset (the "lower strike price").
  2. Sell two call options with a strike price at the current market price of the underlying asset (the "middle strike price").
  3. Buy one call option with a strike price above the current market price of the underlying asset (the "higher strike price").

The result is a position that is long two options (the lower and higher strike price calls) and short two options (the middle strike price calls). The butterfly strategy is typically implemented with at-the-money (ATM) options, meaning the middle strike price equals the underlying asset's current market price.

Key Characteristics of the Butterfly Strategy

The butterfly strategy has several key characteristics, including:

  1. Limited risk: The maximum potential loss is limited to the net premium paid for the four options contracts. This is because the long options limit the potential loss from the short options.
  2. Limited profit: The maximum potential profit is limited to the difference between the middle strike price and the lower or higher strike price, minus the net premium paid for the four options contracts.
  3. Neutral strategy: The butterfly strategy is a neutral strategy, meaning it is designed to profit from a relatively stable underlying asset price. The strategy is not designed to profit from a bullish or bearish market.
  4. Time decay: The butterfly strategy benefits from time decay, as the options contracts sold (short) lose value over time.

Benefits of the Butterfly Strategy

The butterfly strategy has several potential benefits, including:

  1. Limited risk: As mentioned earlier, the maximum potential loss is limited to the net premium paid for the four options contracts. This can be attractive to risk-averse traders.
  2. Limited profit: While the maximum potential profit is limited, it can be attractive to traders who prefer to take smaller profits with limited risk.
  3. Neutral strategy: The butterfly strategy can be a useful tool for traders who have a neutral outlook on the underlying asset price. This is because the strategy is not dependent on the underlying asset price moving in a particular direction.

Drawbacks of the Butterfly Strategy

The butterfly strategy also has several potential drawbacks, including:

  1. Limited profit: While the limited profit potential can be a benefit for some traders, it can be a drawback for those who prefer to take larger profits.
  2. Limited market conditions: The butterfly strategy is most effective when the underlying asset price is relatively stable. In highly volatile markets, the strategy may not be as effective.
  3. High transaction costs: The butterfly strategy involves the use of four options contracts, which can result in higher transaction costs compared to other options trading strategies.

Examples of the Butterfly Strategy in INR

Let's take a look at two examples of the butterfly strategy in INR.

Example 1: Long Butterfly Strategy

Assume that the current market price of XYZ stock is INR 1,000. A trader implements a long butterfly strategy as follows:

  1. Buy one XYZ call option with a strike price of INR 950 for a premium of INR 20.
  2. Sell two XYZ call options with a strike price of INR 1,000 for a premium of INR 30 each.
  3. Buy one XYZ call option with a strike price of INR 1,050 for a premium of INR 10.

The net premium paid for the four options contracts is (20 x 1) + (30 x -2) + (10 x 1) = -INR 20. This means the trader receives a credit of INR 20.

If the price of XYZ stock remains stable at INR 1,000 at expiration, both the lower and higher strike price calls will expire worthless, and the trader will profit from the two middle strike price calls. The maximum potential profit is the difference between the middle strike price and the lower or higher strike price, minus the net premium paid for the four options contracts. In this case, the maximum potential profit is (1,000 - 950) x 2 - 20 = INR 30.

If the price of XYZ stock increases to INR 1,025 at expiration, the lower strike price call will expire in-the-money and be worth INR 75, while the higher strike price call will expire worthless. The two middle strike price calls will also expire worthless, resulting in a net profit of INR 55 (75 - 20).

If the price of XYZ stock decreases to INR 975 at expiration, the higher strike price call will expire in-the-money and be worth INR 75, while the lower strike price call will expire worthless. The two middle strike price calls will also expire worthless, resulting in a net profit of INR 55 (75 - 20).

Example 2: Short Butterfly Strategy

Assume that the current market price of ABC stock is INR 800. A trader implements a short butterfly strategy as follows:

  1. Sell one ABC call option with a strike price of INR 750 for a premium of INR 40.
  2. Buy two ABC call options with a strike price of INR 800 for a premium of INR 20 each.
  3. Sell one ABC call option with a strike price of INR 850 for a premium of INR 10.

The net premium received for the four options contracts is (40 x -1) + (20 x 2) + (10 x -1) = INR 30. This means the trader receives a credit of INR 30.

If the price of ABC stock remains stable at INR 800 at expiration, all four options contracts will expire worthless, and the trader will profit from the net premium received, which is INR 30.

If the price of ABC stock increases to INR 825 at expiration, both the lower and higher strike price calls will expire in-the-money, while the two middle strike price calls will expire worthless. The maximum potential loss is the difference between the middle strike price and the lower or higher strike price, plus the net premium received for the four options contracts. In this case, the maximum potential loss is (825 - 800) x 2 + 30 = INR 55.

If the price of ABC stock decreases to INR 775 at expiration, both the lower and higher strike price calls will expire worthless, while the two middle strike price calls will expire in-the-money. The maximum potential loss is the difference between the middle strike price and the lower or higher strike price, plus the net premium received for the four options contracts. In this case, the maximum potential loss is (800 - 775) x 2 + 30 = INR 55.

Conclusion

The butterfly strategy is an options trading strategy that involves buying and selling four options contracts with the same expiration date but different strike prices. It is designed to profit from a narrow range of prices for the underlying asset and has limited risk and profit potential. The strategy benefits from time decay and can be useful for traders with a neutral outlook on the underlying asset price. However, it may not be effective in highly volatile markets and can result in higher transaction costs.

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