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 index is trading at $140 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 index. This trader enters a Butterfly spread by choosing the following options:
Buy one October 135 Call at $5.65
Sell two October 140 Call at $2.50 (5.00)
Buy one October 145 Call at $ .80
Net debit equals $1.45
Consider the two possible scenarios at expiration:
Index at $140
The short October 140 calls and the long October 145 call all expire worthless but the long October 135 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
Index below $130 or above $150
Maximum loss will occur if the index is below $135 or above $145. With the index closing at $135 all options will expire worthless resulting in a maximum loss of $1.45. If the index closes above $145 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 index 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.