Question

You wish to construct a short butterfly using the following options. Draw the contingency graph and fully label the graph. (You must label the corresponding dollar values for the max gain, max loss, and the spot rates for break-even point(s), and all kinks)

      The following are contract characteristics of various options:

      A: Put option with a strike price of $0.75 and a premium of $0.04

      B: Put option with a strike price of $0.82 and a premium of $0.08

      C: Put option with a strike price of $0.89 and a premium of $0.15

Answer 1

Sell 1 ITM Put Buy 2 ATM Puts Sell 1 OTM Put

Limited Profit

Maximum profit is attained for the short put butterfly 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 higher striking price, all the put options expire worthless and the short put butterfly trader keeps the initial credit taken when entering the trade.

If, instead, the stock price at expiry is equal to the lower strike price, the lower striking put option expires worthless while the "profits" of the remaining long put is canceled out by the "loss" incurred from shorting the higher strike put. So 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 Lower Strike Short Put OR Price of Underlying >= Strike Price of Higher Strike Short Put

Short Put Butterfly Payoff Diagram