When to use: Short Call Butterfly Spread strategy is used when the investor believes that the stock is going to be volatile in the near future.
How it works: Short call butterfly spread uses four option contracts with the same expiry date but three different strike prices. In this strategy, you buy 2 at-the-money call options; sell/write 1 in-the-money call option and 1 out-of-the-money call option, each with the same expiry date, T.
For example: On 27th August 2013, when the share of Axis Bank Limited was trading at Rs. 900.00, you decide to buy 2 at-the-money call options at a premium of Rs. 56.55; sold 1 in-the-money call option at a premium of Rs. 105.95, with a Strike Price of Rs. 800.00; sold 1 out-of-the-money call option at a premium of Rs. 22.15, with a Strike Price of Rs. 1,000.00, all expiring on 26th September 2013.
For Long Call Options: If the price of Axis Bank share rises above Rs. 900.00 (i.e. strike price of the 2 long call positions), you can exercise your respective option(s), but the price of the stock must rise above Rs. 956.55 (i.e. strike price + the amount of premium you paid for each option) for you to exercise your option(s) and make a profit.
For Short Call Options: If the price of Axis Bank share stays below Rs. 800.00 and/or Rs. 1,000.00 (i.e. the respective strike prices for the 2 short call positions) until expiry, you will retain the appropriate premium amount (i.e. based on the price of the underlying share upon expiry). If however the price rises above Rs. 800.00 or Rs. 1,000.00, the buyer of call option may exercise his option and make a profit based on the extent to which the stock price rises. From the perspective of the seller of the call (you), you will start suffering a loss once the stock price rises above Rs. 928.10 (i.e. lower strike price + total premium received on the two short call options).
Risk/Reward: In short call butterfly spread, the maximum risk can be calculated by subtracting the net premium received, from the difference between the middle and the lower strike price while the maximum reward/profit is limited to the net premium received for the positions.
The table below shows the net payoff of short call butterfly spread strategy at 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 underlying share equals Rs. 815.00 and Rs. 985.00.
First Break-even Point = Lowest Strike price + net premium received = Rs. 815.00 (800.00 + 15.00)
Second Break-even Point = Highest Strike price – net premium received = Rs. 985.00 (1,000.00 – 15.00)
The maximum profit which the investor can make is equal to the net premium received (i.e. Rs. 15). The maximum profit, in this example will result if the share price remains below the lower strike price (i.e. Rs. 800.00) or rises above the higher strike price (i.e. Rs. 1,000.00) on expiry.
The maximum loss (i.e. Rs. 85.00) will be incurred if the share price equals the middle strike price (i.e. Rs. 900.00) upon expiry.
Maximum Loss = Middle Strike Price (Rs. 900) – Lower Strike Price (Rs. 800) – Net premium recieved (Rs. 15) = Rs. 85.00
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 Short 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 Axis Bank’s call option contract is for 250 shares. Accordingly the net premium received will be Rs. 3,750 for 4 lots (i.e. Rs. 15.00 *250) 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 market conditions. In the above example, as a seller of call option, you will have to deposit a margin of Rs. 69,075 (i.e. Strike price * Lot size * 15.35%) for selling/writing 2 lots of Axis Bank’s call option. Note that the total value of your outstanding position in this case will be Rs. 4,50,000 (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