Given the following 3 put options that have the same expiration date: A: Strike Price =...

Given the following 3 put options that have the same expiration date:

A: Strike Price = $110, Market Price = $6

B: Strike Price = $120, Market Price = $10

C: Strike Price = $130, Market Price = $16

Explain how a butterfly spread can be created. Create a table in excel showing the profit from this. What range of stock prices would lead to a loss from this?

Solutions

Expert Solution

2 butterfly spread can be created here :

1) Long butterfly spread with puts : A long butterfly spread with puts consist of buying put with highest strike price and the lowest strike price and selling two puts of the middle strike price. This means buying the wings and selling the body.
Maximum Profit in this strategy will be the the difference between the highest and centre strike price minus the net initial premium paid.
Maximum loss in this strategy is limited to the initial premium paid.

Long Butterfly spread can be created by buying put with Strike Price $ 110, buying put with strike price $ 130 and selling 2 put with strike price 120.
Premium Paid/Received will be as below :
Purchase of put with Strike Price 110 resulting in initial outflow of $6.
Selling of 2 put with Strike Price 120 resulting in initial inflow of $10 * 2 = $20.
Purchase of put with Strike Price 130 resulting in initial outflow of $16.

Net Initial Outflow = $6+$16-$20 = $2
Maximum Loss from this strategy will be net initial outflow = $2
Maximum Profit from this strategy will be difference in strike price in net initial outflow = $130-120 - $ 2 = $10 - $2 = $8

Hence maximum profit is $8 when Strike Price is $120 and maximum loss is restricted to $2.

2) Short butterfly spread with puts : A short butterfly spread with puts consist of selling put with highest strike price and the lowest strike price and buying two puts of the middle strike price. This means selling the wings and buying the body.
Maximum Loss in this strategy will be the the difference between the highest and centre strike price minus the net initial premium received.
Maximum profit in this strategy is limited to the initial premium received.

Long Butterfly spread can be created by selling put with Strike Price $ 110, selling put with strike price $ 130 and buying 2 put with strike price 120.
Premium Paid/Received will be as below :
Selling of put with Strike Price 110 resulting in initial inflow of $6.
Buying of 2 put with Strike Price 120 resulting in initial outflow of $10 * 2 = $20.
Selling of put with Strike Price 130 resulting in initial inflow of $16.

Net Initial Inflow = $6+$16-$20 = $2
Maximum Profit from this strategy will be net initial outflow = $2
Maximum Loss from this strategy will be difference in strike price in net initial outflow = $130-120 - $ 2 = $10 - $2 = $8

Hence maximum loss is $8 when strike price is $120 and maximum profit is restricted to $2.

jeff jeffy answered 1 year ago

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