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Short Butterfly

short butterfly

short butterfly

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 in the money call
buy 2 at the money calls
sell 1 out the money call

short call butterfly

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.

limited profit

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:

  •  max profit = net premium received - commissions paid
  •  max profit achieved when price of underlying = strike price of higher strike short call

short-butterfly

limited risk

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:

  • max loss = strike price of long call - strike price of lower strike short call - net premium received + commissions paid
  • max loss occurs when price of underlying = strike price of long calls

breakeven point(s)

there are 2 break-even points for the short butterfly position. the breakeven points can be calculated using the following formulae.

  •   upper breakeven point = strike price of highest strike short call - net premium received
  •   lower breakeven point = strike price of lowest strike short call + net premium received

example

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.

note: while we have covered the use of this strategy with reference to stock options, the short butterfly is equally applicable using etf options, index options as well as options on futures.

commissions

for ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

however, for active traders, commissions can eat up a sizable portion of their profits in the long run. if you trade options actively, it is wise to look for a low commissions broker. traders who trade large number of contracts in each trade should check out optionshouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).

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