When to use: Long Call Butterfly spread strategy is used when the investor believes that the stock is going to be less volatile in the near future.
How it works: Butterfly spreads use four option contracts with the same expiry date but with three different strike prices. In this strategy, you sell/write 2 at-the-money call options; buy 1 in-the-money call option and 1 out-of-the-money call option, each with the same expiry date, T.
For example: On 23rd August 2013, when the share of Jaiprakash Associates Limited was trading at Rs. 35.00, you decided to sell/write 2 at-the-money call options at a premium of Rs. 7.50 expiring 26th September 2013; bought 1 in-the-money call option at a premium of Rs. 4.20, with a Strike Price of Rs. 32.50; bought 1 out-of-the-money call option at a premium of Rs. 3.40, with a Strike Price of Rs. 37.50.
For Short Call Options: If the price of the share stays below Rs. 35 (i.e. the strike price of the 2 short call options) until expiry, you will retain the entire premium amount (i.e. Rs. 7.50). If however the price rises above Rs. 35, the buyer of the call option may exercise his option and make a profit based on how far above Rs. 35 does the stock price rise. From the perspective of the seller of the call (you), you will start suffering a loss once the stock price rises above Rs. 38.75 (i.e. strike price + premium).
For Long Call Options: If the price of Jaiprakash Associates share rises above Rs. 32.50 and/or Rs. 37.50 (i.e. the respective strike prices for the 2 long call options), you can exercise your respective options, but the price of the stock must rise above Rs. 40.10 (i.e. lower strike price + the amount of total premium you paid for the long call options) for you to exercise your option and make a profit.
Risk/Reward: In a long call butterfly spread, the risk is limited to the net premium paid for the position and the maximum reward/profit is calculated by subtracting the net premium paid, from the difference between the middle and the lower strike price.
The table below shows the net payoff of long butterfly spread strategy assuming different spot prices on the expiry date:
The table above allows you to easily see the break-even points, maximum profit and loss potential at expiry in rupee terms. The calculations are presented below.
The two break-even points occur when the price of the underlying share equals Rs. 32.60 and Rs. 37.40.
First Break-even Point = Lowest Strike price + net premium paid = Rs. 32.60 (32.50 + 0.10)
Second Break-even Point = Highest Strike price – net premium paid = Rs. 37.40 (37.50 – 0.10)
The maximum profit (i.e. Rs. 2.40) will be made if the share price upon expiry equals the middle strike price (i.e. Rs. 35 on expiry).
Maximum Profit = Middle Strike (35) – Lower Strike (32.50) – Net premium paid (0.10) = Rs. 2.40
The maximum loss which the investor may suffer is equal to the net premium paid i.e. Rs. 0.10. Maximum loss, in this example, will be incurred if the share price falls below the lower strike (i.e. Rs. 32.50) or rises above the higher strike (i.e. Rs. 37.50) on the expiry date.
How to use the Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Long Call Butterfly Spread Option Strategy.
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example Jaiprakash Associates Limited’s call option contract is for 4000 shares. Accordingly the net premium paid will be Rs. 400 for 4 lots (i.e. 0.1 *4000) in our example.
Also Note: Unlike the buyer of an option who only pays the premium to buy the option, the seller of an option must deposit a margin amount with the exchange. This is because he takes an unlimited risk as the stock price may rise to any level. In case the price rises sharply above the strike price, the exchange utilises the margin amount to make good the profit which the option buyer makes. The amount of margin is decided by the exchange and it typically ranges from 15 % to 60 % based on the volatility in the underlying stock and in market conditions. In the above example, as a seller of call option, you will have to deposit a margin of Rs. 66,948 (i.e. Strike price * Lot size * 13.98%) for selling/writing 2 lots of Jaiprakash Associates Limited call option. Note that the total value of your outstanding position in this case will be Rs. 2,80,000 (i.e. strike price * lot size).
About the Author
Rajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.Follow @SanaSecurities