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Butterfly spread is one of the most important spread trading strategy used by traders. It involves position in options with three different strike prices.
It can be created by buying a call option with a lower strike price X(1), buying a call option with a relatively high strike price X(3), and selling two call options with a strike price X(2), halfway between X(1) and X(3).
A butterfly spread leads to profit if the stock price stays close to X(2),but ends in loss (though it is small) if there is a significant price movement in either direction.
It is therefore an appropriate strategy for an investor who thinks large price movements are unlikely.
This strategy requires a small initial investment. An example would clear things up.
Nifty closed at 5,703.3 on Friday. Now 5,700 call for October series is quoting at Rs 107.5, similarly 5,800 call and 5,600 call are quoting at Rs 171.5 and Rs 60.6 respectively.
A butterfly spread can be created by buying 5,800 call and 5,600 call and selling two 5,700 call. Total investment is Rs 17.9 (60.6+171.5- 2*107.1=17.9).
So if the Nifty is trading greater than 5,617 or less than 5,783 then this strategy is profitable, and if the Nifty is higher than 5,800 or less than 5,600 then the investor loses his initial investment i.e. Rs 17.9.
If the Nifty closes in between 5,600-5,617 and 5,783-5,800 range then the investor recovers some of his/her initial investment but overall it will be in loss though less than Rs 17.9.
It has to be noted that we are not including broking charges, inclusion of broking charges will reduce range at which the Nifty has to close.
The maximum profit from this strategy is Rs 82.1 when the Nifty closes at 5,700.
Butterfly spreads can also be created using put options. In this case, the investor buys a put with a low strike price, buys a put with a high strike price, and sells two puts with an intermediate strike price.
The butterfly spread in the above example would be created by buying a 5,600 and 5,800 put and selling two 5,600 put.
If investors think that there will be volatility than they can short the butterfly spread, by reversing the above positions.
>shaurya.mishra@thehindu.co.in
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