Question

1. a)    Demonstrate how a butterfly spread can be constructed using either put or call options and discuss the circumstances under which a trader might construct such a strategy.

Answer 1

The long butterfly is a limited risk, neutral option startegy that consists of simultaneously buying a call(put) spread and selling a call(put) spread that share the same short strike. All options use the same expiration cycle. Additionally, the distance between the short strike and long strike should be equal for standard butterfly positions.

Example of a call butterfly

Long100/105 call spread, short 105/110 call spread

(+1 long 100 call,-2 short 105 call, +1long 110 call)

Example of put butterfly

Short 100/105 put spread, long 105/110 put spread

(+1 long 100 put, -2short 105 put, +1 long 110put)

So, long butterfly strategy characteristics

Maximum profit potential. (Width of long

Spread- debt paid)

*100

Maximum loss potential=debit paid*100

So, Expiration breakeven

Upper breakeven

I) long call butterfly

Short strike+(width of call spread- debit paid)

ii) Long put butterfly

Higher long put strike- debit paid

Lower Breakeven

Long call butterfly

Lower long call strike+ debit paid

Long put butterfly

Short strike-(width of long put Spread-debit paid)

A butterfly spread has low probability and low risk. That measures there is a low probability of profit but also a low probability of large losses. For that reason traders can use the strategy when they are feeling speculative.

An investor who speculates that a stock won't move very much from its current price can create a butterfly spread by buying one in the month (ITM) option, selling two at the money (ATM) option and buying one out of the money (OTM) option.

This leads to paying a debit when opening the trade,which will affect the max profit.