It is usual for derivatives traders to adopt several trading and hedging strategies to moderate the risk exposure of their position. Creating a spread is a common hedging technique. It involves buying one security and selling related security units. Since the price of a derivative depends on the underlying asset, spread allows traders to create a cushion and limit their losses.
In finance, spread refers to the difference between prices (buying and selling), yields, or rates. Bid and ask is quite common and widely used. But traders also use several other spread techniques, including short call butterfly. It has derived its name from the shape it creates on the chart.
Short call butterfly formation consists of two long calls at a middle strike and two short calls at upper and lower strike rates. Both short call options or the wings form at equidistant from the middle strike (body). And, all the contracts in the short call butterfly formation have the same expiry date. This strategy allows traders to profit when the underlying asset price expires outside the wings.
What is butterfly spread?
Butterfly spread refers to an options strategy that combines bull and bear spreads with a fixed risk and capped profit. A butterfly strategy is more effective when the asset price is moderately volatile. Since it is a market-neutral strategy, the payoff is more when asset price doesn’t move extensively close to expiry. It combines four calls or four puts.
What is a short call butterfly?
A trader initiates a short call butterfly strategy when he expects some volatility in the asset price, especially to capture movements outside the wings of the spread at expiration. It is a strategy that limits risks but also cap rewards. The purpose is to predict an upcoming trend in either direction correctly.
It is a three-part strategy created by selling one call at a lower strike price, buying two contracts at a higher strike price, and selling another at an even higher strike price.
Short butterfly spread generates profit when the asset price moves in either direction. It means there is no forecast on-trend, but you can bet on volatility, especially when asset price volatility is low and you expect it to rise. It is a situation that compromises both risk and rewards. The highest profit from the spread equals the net premium received, minus any commission. It is realised when asset price remains above the highest strike price or below the lowest strike price on expiration.
Here is a real-life situation.
- Sell one ITM call of ABC 95 stocks at Rs 534
- Buy 2 ATM calls of ABC 100 at Rs 230 each or Rs 460
- Sell one call of ABC 105 at Rs 150
- The net credit is equal to Rs 224
The maximum risk is the distance between the strike price minus the net premium. It can happen if the stock price equals the strike price of the short call on expiry.
However, short call butterfly is an advanced trading strategy, including three steps and high cost. Since it involves three strike prices, there are multiple commissions in addition to bid-ask spread during opening and closing positions. Hence, traders always try to open and close at a ‘good price’. After calculating the risk and reward ratio, including commissions, ensuring that the contract expires at a profit is essential.
Analysing short call butterfly spread
Short call butterfly is the best strategy when one is sure of the underlying security to move in any direction, up or down. It is an advanced strategy reserved for experienced players.
Short call butterfly is a limited reward situation where the maximum profit is the net premium minus paid commissions. Two conditions can lead to a gain from the spread.
1. The contract will expire worthlessly when the stock price is below the lowest strike price, and the contract writer retains net credit as income.
2. When the underlying stock price is above the highest strike price, all calls are in the money. The net value of the butterfly spread becomes zero. Hence, net income is net credit minus any commission.
Short call butterfly is a limit risk strategy. Hence, one needs to calculate the maximum risk/loss one can incur in executing the spread.
The maximum loss is the difference between the lowest and centre strike prices in a short call butterfly strategy, less the net credit received after commission. It occurs when the asset price equals the strike price of the short calls on expiration.
The breakeven point in the option spread is the no loss, no profit situation, and it can occur twice in the short call butterfly. The lowest breakeven point occurs when asset price equals the minimum strike price plus net credit. The second breakeven point is when the asset price equals the higher short call strike, less any net credit.
The strategy realises maximum profit when asset price expires below the lowest strike price or higher than the highest strike price, which can happen when there is high volatility and price moves outside the range of the butterfly.
Discussing short call butterfly strategy
Short call butterfly is a strategy of choice when the forecast for the asset price is to expire outside the spread’s range. Unlike long straddles or long strangles, the profit potential from the strategy is limited. Moreover, in terms of commission payouts, it is also more expensive than the two strategies mentioned above. However, profit opportunities are limited with short call butterflies than straddles or strangles.
Butterfly spreads are sensitive to volatility. The price of short call butterfly rises when volatility falls and vis-a-vis. Traders opt for the strategy when asset price moves in a close range, but the market forecasts rising volatility.
Some traders enter a butterfly spread when volatility is low. In most cases, volatility rises in options prices rise as the expiration date approaches. Hence, traders would sell a butterfly spread seven to ten days before expiration and close their positions the day before the option contract expires.
Profit realisation happens when volatility increases or the underlying asset prices close outside the spread’s range. If volatility and asset price remain unchanged, the traders will incur losses.
Patience is essential while executing short-call butterflies since volatility rises with the approach of the expiration date. Trading discipline is needed, especially as the contract nears expiration since small changes in the underlying asset’s price can significantly impact the spread’s price.
Let’s consider the impact of the three critical factors of asset price change, volatility, and time on short call butterfly when any of these change.
Change in asset price
‘Delta’ estimates the impact of asset price change on the spread. Long calls have positive Delta, and short calls have negative Delta. However, Delta remains close to zero for the short call butterfly irrespective of underlying asset price change.
Increase in volatility
Volatility is the measure of a percentage shift in stock price. As volatility rises, long options become expensive considering the time to expiration, when the stock price remains constant. The opposite situation occurs for short options contracts. Vega is the measure of how changing volatility impacts the value of the net position.
Short call butterfly has a positive Vega, meaning it experiences a price decline when volatility rises and the spread makes money. In the opposite situation, the spread price increases when volatility is low, and the trader loses money in the spread.
The spread is sensitive to volatility. Hence, it is a good strategy when volatility is low but expected to rise.
Options spreads tend to lose value as expiration approaches. It is called time erosion. Theta measures how the net price of options changes with time erosion. Long options positions have negative Theta when other factors like stock price and volatility remain constant. Short options have a positive Theta, meaning their value rises with time erosion.
The short call butterfly has a negative Theta when asset price moves between the lowest and highest strike prices. When the stock price moves out of the range, Theta value rises as the expiration date approaches.
- Short call butterfly is a trading strategy when market volatility is low but expected to rise.
- It is a trading strategy that limits both risk and rewards.
- Short call butterfly is sensitive to volatility. Hence, traders make a profit from exercising the spread when volatility rises.
- Traders profit in short call butterfly if stock price expires below the lowest strike price or higher than the highest strike price.
- Conversely, the spread expires in loss if stock price equals the middle strike price on expiry.
- It is a complex spread, involving three steps of opening long and short positions and paying commissions. Hence, it is reserved for experienced traders.
The bottom line
Options trading involves several strategies to hedge against market volatility. Short call butterfly is one of them.
Now that you have learned ‘what is a short call butterfly?’, strengthen your trading strategies to optimise returns from your positions.
What is a short call butterfly?
Short call butterfly is a three-part trading spread created by selling one call option at a low strike price, buying two contracts at a higher strike price, and selling another contract at an even higher strike price.
Can I experience loss in a short call butterfly?
The strategy limits your risk but doesn’t eliminate it completely. A loss can occur when the asset price expires at the middle strike price. The maximum loss is the middle strike price, minus the lowest strike price and the premiums paid.
What is the highest profit from a short call butterfly?
A trader makes a profit from a short call butterfly when the asset price moves outside the lowest and highest strike price range. The trade makes a profit when the stock price expires lower than the lowest strike price or higher than the highest strike price. The highest profit value is net credit received less any commission paid.
When should I buy a short call butterfly?
Traders enter a short call butterfly spread when market volatility is low, but a forecast suggests rising volatility at the time of expiration.