Butterfly - Equity Example

Example

Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.

XYZ is trading at $40 in September. An options trader wants to implement a limited risk, non-directional trading strategy on XYZ which is viewed as being a low volatility type stock. This trader enters a Butterfly spread by choosing the following options:

Buy one October 35 Call $5.65
Sell two October 40 Calls at $2.50 (5.00)
Buy one October 45 Call at $ .80
Net debit equals $1.45

Consider the two possible scenarios at expiration:

Stock at $40
The short October 40 calls and the long October 45 call all expire worthless but the long October 35 call is all intrinsic value and now worth $5. But remember it cost us $1.45 to initiate this trade so our maximum profit is $3.55 = $5 - $1.45

Stock below $30 or above $50
Maximum loss will occur if the stock is below $35 or above $45. With the stock closing at $35 all options will expire worthless resulting in a maximum loss of $1.45. If the stock closes above $45 any profit attained from the two long calls will be offset by the two short calls and once again the maximum loss of $1.45 will occur, which was the price paid to initiate the trade.

For those who are neutral on a particular stock over the near-term, and who require a known, limited risk and reward, the Long Call Butterfly Spread might be an appropriate strategy to use. Purchasing a Long Call Butterfly Spread one time can usually require a small initial cash investment to achieve a profit if your neutral forecast proves correct.