Trading Strategy - Butterfly Spreads

The last post on Trading Strategy was related to Spreads. You will remember well that it was a Limited Risk, Limited Profit Strategy. I also explained that there are Bull Call Spreads, Bear Call Spreads, etc. While most of them are obvious to you once you are aware of one... Butterfly Spread Strategy is an interesting mixture which I promised that I will cover in a post. Today is the day.

Butterfly Spread is a mixture of Bull Spread and Bear Spread and it consists of three Strike Prices. It is a Neutral Strategy which is again Limited Risk and Limited Profit play. It is usually employed when you think that the stock/index will not move much till the next expiry (low volatility). It is slightly tricky to explain theoretically hence lets use an example.

Let's say NIFTY is at 4800 and you expect it to stay there till the expiry of current cycle without much movement on either side. In such case you enter following trades (all Premium values are close to actual with little bit rounding off);

• You buy one In the Money (ITM) Call of 4600 at 225Rs - Premium paid 11250/-
• You sell two At the Money (ATM) Calls of 4800 at 100 Rs each - Premium received 10000/-
• You buy one Out of the Money (OTM) Call of 5000 at 35 Rs - Premium paid 1750/-

(I am not considering trading charges here. Please read earlier posts in case you are not following Premium calculations or Options Terminologies here.)

Below graph shows how will we fare with respect to NIFTY movement.

As you can see above, the maximum you loose is difference between the Premiums paid and received. So;

Maximum Loss = Net Premium Paid (60 Rs in this case) and it occurs when;

NIFTY is either lower (or equal) to Lower Strike or higher (or equal) to Higher Strike.

Maximum Profit = (Diff between Strike Price of Short Call and Lower Strike) - Net Premium

It occurs when; NIFTY = Strike Price of Short Call

So Maximum Profit = (4800-4600=200)-(60) = 140 Rs at 4800 NIFTY

Lower Break-even = Lower Strike Price + Net Premium = 4600+60 = 4660

Upper Break-even = Higher Strike Price - Net Premium = 5000-60 = 4940

This is the zone between which you make money.

So you are risking 60 Rs (60x50 = 3000 Rs) for a potential gain of 140 Rs (140x50 = 7000 Rs). However, note that this strategy is useful in sideways market. In a strong trending or volatile market, you will loose money more often than gaining.

The middle Strike is called as Body and two Strikes on either side are called as Wings. Now you can guess why the name Butterfly for this one. For once it makes sense. Another interesting derivation of this Strategy is when the Center Strike Price is not single one but two... means rather than shorting two Calls of one single Strike, you short one Call each of two close Strike Price in the Center. This is called as Iron Condor and you can read more about it here. Rather than a pointed cliff in above graph, it has a graph which resembles a flat top between two Center Strikes. Do let me know in case you want more on it. Until next post.

Happy Trading.

Note: My apologies for some mismatch in example and figures on the chart (only legends). Will correct them in the evening as I do not have access to it right now. Meanwhile you can read 4700 as 4600, 4900 as 4800 and 5100 as 5000 in the legends area. Chart otherwise is okay.