A short butterfly spread with calls is a sophisticated, three-part options strategy designed for investors who anticipate that the underlying asset's price will move significantly away from a central strike price, or that it will expire outside of a narrow range around that strike, by the expiration date. It's a strategy that offers limited profit potential with limited risk.
Understanding the Short Butterfly Spread with Calls
As referenced, a short butterfly spread with calls is a three-part strategy created by selling one call at a lower strike price, buying two calls with a higher strike price, and selling one call with an even higher strike price. All calls involved in the spread must have the same expiration date, and their strike prices are equidistant. This means the difference between the lower and middle strike is the same as the difference between the middle and upper strike.
This strategy can be understood as combining two vertical spreads: a bear call spread and a bull call spread, or alternatively, selling a long call butterfly spread.
Components of a Short Call Butterfly Spread
The construction of a short call butterfly spread involves four call options across three distinct strike prices, all with the same expiration date. Let's break down the legs:
- Sell 1 Call (Lower Strike Price): This is typically an in-the-money (ITM) call option.
- Buy 2 Calls (Middle/Higher Strike Price): These are usually at-the-money (ATM) calls. These calls form the "body" of the butterfly.
- Sell 1 Call (Upper/Even Higher Strike Price): This is generally an out-of-the-money (OTM) call option.
The strike prices are evenly spaced, creating a symmetrical risk/reward profile.
Here’s a table illustrating the structure:
| Action | Option Type | Strike Price (Relative) | Position | Typical Moneyness |
|---|---|---|---|---|
| Sell | Call | Lower | Short | In-the-Money (ITM) |
| Buy (x2) | Call | Middle / Higher | Long | At-the-Money (ATM) |
| Sell | Call | Upper / Even Higher | Short | Out-of-the-Money (OTM) |
When to Use a Short Butterfly Spread
A short butterfly spread is typically employed when an options trader expects the underlying asset to:
- Move Significantly: The primary outlook is for a substantial move (either up or down) away from the central strike price before expiration.
- Avoid the Middle: Traders predict that the price will not expire exactly at or very close to the middle strike price.
This strategy is profitable if the stock price moves outside the two middle strikes (the "body" of the butterfly) and closer to or beyond either of the outer strike prices (the "wings").
Example of a Short Call Butterfly Spread
Let's consider a hypothetical example for Stock XYZ, currently trading at $100, with all options expiring in one month:
- Sell 1 Call Option: Strike Price $95 (Lower/ITM) for a premium of $6.00
- Buy 2 Call Options: Strike Price $100 (Middle/ATM) for a premium of $3.00 each ($6.00 total)
- Sell 1 Call Option: Strike Price $105 (Upper/OTM) for a premium of $1.00
Net Credit/Debit Calculation:
- Premium Received (Sold Calls): $6.00 (from $95 strike) + $1.00 (from $105 strike) = $7.00
- Premium Paid (Bought Calls): $3.00 * 2 = $6.00
- Net Credit: $7.00 - $6.00 = $1.00
In this example, the trader receives a net credit of $1.00 per share (or $100 per contract).
Profit/Loss Scenarios at Expiration:
- Maximum Profit: Occurs if the stock price closes significantly below the lower strike ($95) or significantly above the upper strike ($105). In either case, all calls expire worthless, and the trader keeps the initial net credit of $100.
- Maximum Loss: Occurs if the stock price closes exactly at the middle strike price ($100). In this scenario, the two purchased $100 calls would be in-the-money, and the sold $95 and $105 calls would have specific values, leading to the maximum loss which is the difference between the middle and lower (or upper) strike prices, minus the net credit received. In this case, if XYZ closes at $100, the $95 call is ITM by $5, the $100 calls are ATM, and the $105 call is OTM. The maximum loss would be the difference between the closest strikes ($5) minus the net credit ($1), so $4.00 per share, or $400 per contract.
Key Benefits and Risks
Benefits:
- Limited Risk: The maximum potential loss is capped, occurring if the underlying asset's price expires precisely at the middle strike price.
- Defined Profit Potential: The maximum profit is also limited to the net credit received when opening the spread, realized if the price moves sufficiently far from the middle strike.
- Versatility: Can be structured with calls or puts, allowing for different market outlooks.
Risks:
- Precision Requirement: The strategy requires the underlying asset to move away from the middle strike. If it consolidates around the middle strike, it results in the maximum loss.
- Low Probability of Max Profit: While limited, achieving the maximum profit (all options expiring worthless or fully offsetting) requires a significant price movement.
- Commission Costs: Due to the four-leg nature, transaction costs can be higher.
A short butterfly spread is a nuanced strategy, best suited for experienced options traders who have a strong conviction about future volatility or lack thereof relative to a central price point.
