Session 3: Case Study Covered Call and Butterfly Strategies
B. Butterfly strategy
1. What is the Butterfly strategy?
* A neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from.
2. What are its advantages and disadvantages?
* Large profit percentage due to low cost involve in executing the position Limited risk should the underlying asset rally or ditch unexpectedly Maximum loss and profits are predictable
* Larger commissions involved than simpler strategies with lesser trades Not a strategy that traders with low trading levels can execute
3. How to price and enter into the Butterfly as one trade?
* The trader sells two option contracts at the middle strike price and buys one option contract at a lower strike price and one option contract at a higher strike price. Both puts and calls can be used for a butterfly spread. * Prices or premium will differ according to strike prices and time to expiration.
4. Why a butterfly trade may be considered by an investor or trader who thinks they have an idea of where a Stock may be at expiration?
* A butterfly spread leads to a profit if the stock price stays close to the strike price of the short calls but gives rise to small loss if there is a significant stock price move in either direction. * It is therefore an appropriate strategy for an investor who feels that large stock prices moves are unlikely.
5. What are the costs of a Butterfly strategy?
* Total cost = long call/put prices - short call/put prices * When implemented properly, the potential gain is higher than the potential loss, but both the potential gain and loss will be limited. * Butterfly spreads have limited risk, meaning you can only lose your initial investment.
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