Introduction To Short Call Butterfly Option Strategy
The short butterfly is an options strategy that involves the use of call options at 3 different exercise or strike prices derived from the same underlying security and have the same expiration date. It is classified as a neutral options trading strategy with an anticipation towards high volatility of the underlying security.
Short butterfly vs Long butterfly
A short butterfly is executed in anticipation of increased volatility of the underlying security while the long butterfly is executed in anticipation of low volatility. In a period of low volatility, a long butterfly trade stands a chance of making a profit.
Comparable strategies to short butterfly
Options trading strategies that are comparable to the short butterfly are the reverse iron condor, short condor and short put butterfly. These strategies have limited potential profit and limited potential losses.
The options trading strategy that most resembles the short butterfly is a short put butterfly as there is only 1 price point at which a maximum loss is experienced. The short put butterfly however is created using put options while the short butterfly is created with call options.
Steps
Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Anticipating Increased Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss
Step 7 : Loss calculation for a short butterfly/short call butterfly
Step 8 : Limited potential profit
Step 9 : Calculation of maximum profit for short butterfly/short call butterfly
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing strategy of short butterfly
Step 12 : Exit Trade & Record Trade In Diary
Step 1 : Perform economic, fundamental and technical analysis
Anticipate economic or fundamental events that will cause the price of the underlying security to be volatile. The trader can look out for events such as a new product launch, an upcoming jobs report or approval of a certain drug by the FDA. In any case, be sure to back test the charts by looking at how the underlying security responds to certain events. Some suggested chart patterns to look out for are:
The whole idea is to execute the trade before the breakout occurs. These are just some suggested chart patterns. Of course, the options trader can use other technical analysis tools as well.
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
Step 2 : Outlook – Anticipating Increased Volatility
An options trader who executes a short butterfly is bullish on the volatility of the price of the underlying security. The greater the volatility of the underlying security, the greater the probability of the trade turning a profit. If the price of the underlying security is non volatile or worse still stagnant, the trader stands a chance of making a loss from the short butterfly trade.
Step 3 :Study the option chain
Examine the options chain and select the options for the construction of the short butterfly.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
There are 2 breakeven price points for the short butterfly. If the price of the underlying security fluctuates between the two break even price points, a loss will occur.
The downside breakeven price point can be calculated as:
Net credit received + strike price of written call with lowest strike price
The upside breakeven price point can be calculated as:
Strike price of written call with highest strike price – net credit received
Step 5: Understand Your Profit Zones
After the breakeven points has been calculated, the trader would be able to understand where the profit zone of the strategy is. The profit zone is any price point above the upside breakeven point and below the downside breakeven point.
Step 6 : Limited loss
The loss in a short butterfly is limited. The good news is that the maximum loss of a short butterfly occurs only at one price point. Do refer to the risk/reward profile of the short butterfly. The maximum loss of the short butterfly occurs when the trading price of the underlying security is equal to the exercise(strike) price of the bought calls.
Step 7 : Loss calculation for a short butterfly/short call butterfly
The maximum loss occurs at only 1 price point. As such it can be calculated as :
Strike price of bought call – Strike price of written call with lowest strike price – net credit + commissions paid to broker
The net credit is the net premiums collected when the short butterfly is executed.
Step 8 : Limited potential profit
The potential profit of a short butterfly is limited. For the maximum profit to be realised, the price of the underlying security is greater than or equal to the strike price of the highest strike call or less than or equal to the strike price of the lowest strike call.
Step 9 : Calculation of maximum profit for short butterfly/short call butterfly
The maximum profit can be calculated as:
Net credit received – commissions paid to broker
Step 10 : Calculate Risk & Reward Ratio
After the calculation of maximum profit and maximum loss, the options trader is able to calculate the risk and reward ratio. At this point, the risk and reward ratio should be attractive relative to trades of a similar nature.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Set Up Trade : Executing strategy of short butterfly
- Short 1 in the money call
- Long 2 at the money calls
- Short 1 out of the money call
Hence, the short butterfly is constructed with call options of 3 different strike prices. The ratio above is to be adhered to when executing a short butterfly options trade.
Step 12 : Exit Trade & Record Trade In Diary
After the trade has been exited, the options trader should record the trade’s performance in a diary or a journal and reflect on the entire process. The trader should also find ways to improve his performance and his personal trading algorithm.
Example Of A Short Call Butterfly
XYZ Corp is trading at a price of $60. A trader who anticipates volatility in the underlying security, XYZ Corp executes a short butterfly by:
- Short 1 July 50 call @ $1120 per contract
- Long 2 July 60 calls @ $410 per contract
- Short 1 July 70 call @ $120 per contract
As such the net credit is:
$1120 + $120 – $410 x 2 = $420
The net credit is also the net premium received when the short butterfly is executed.
If the price of XYZ Corp trades at $60, the trader will experience a loss.
At $60 on expiration of the options:
| Beginning value | Ending value | Profit or loss | |
| July 50 call | $1120 | $1000 | Profit = $120 |
| 2 July 60 calls | $410 | $0 | Loss = $410 x 2
= $820 |
| July 70 call | $120 | $0 | Profit = $120 |
| Overall Loss | $820 – $120 – $120 = $580 |
As you can see if the price stagnates, the short butterfly will result in a loss because the short butterfly trade will thrive only in volatile conditions. When the price of the underlying security trades between the upside and downside breakeven price points, a loss will result. In short, conditions of stagnation are not good for a trader using a short butterfly trade.
If the price of the underlying security trades at $90 on expiration:
| Beginning value | Ending value | Profit or loss | |
| July 50 call | $1120 | $4000 | Loss = $2880 |
| 2 July 60 calls | $410 | $3000 | Profit = ($3000 – $410) x 2 = $5180 |
| July 70 call | $120 | $2000 | Loss = $1880 |
| Overall profit | $5180 – $2880 – $1880 = $420 |
As you can see when there is a major price move upwards, a profit is realisable from the short butterfly trade. That profit is also a maximum profit and is equal to the $420 net credit received. The same can be said if there is a major price move downwards. More specifically, if the trading price of the underlying security is greater or equal to the highest strike call or less than or equal to the lowest strike call.
Note that the strike price of a call option is synonymous to exercise price.