Butterfly Spread Option

Butterfly Spread Option, also called butterfly option, is a neutral option strategy that has limited
risk. The option strategy involves a combination of various bull spreads and bear spreads. A
holder combines four option contracts having the same expiry date at three strike price points,
which can create a perfect range of prices and make some profit for the holder. A trader buys
two option contracts – one at a higher strike price and one at a lower strike price and sells two
option contracts at a strike price in between, wherein the difference between the high and low
strike prices is equal to the middle strike price. Both Calls and Puts can be used for a butterfly
spread.

Any butterfly option strategy involves the following:

1) Buying and selling of Call/Put options

2) Same underlying asset

3) Combining four option contracts

4) Different strike prices, with two contracts at same strike price

5) Same expiry date

Example: Suppose, a trader is expecting some bullishness in Reliance Industries, when it

trades at Rs 1,000. Now, a trader enters a long butterfly bull spread option by buying one lot
each of December expiry Call options at strike prices Rs 980 and Rs 1,020 at values of 21.15
(980 Call) and 5.20 (1,020 Call) and then sell lots of Calls at strike price Rs 1,000 at 11.30. The
cost to the trader at this point would be 3.75 (21.15+5.20-(2(11.30)). If the strategy fails, this will
be the maximum possible loss for the trader. If the Reliance Industries stock trades at the same
level (i.e. Rs 1,000) on the expiry date in December end, the Call option at the higher strike
price will expire worthless as out-of-the-money (strike price is more than the trading price), while
the Call option at the lower strike price will be in-the-money (strike price is less than trading
price) and the two at-the-money Call options that had been sold expired worthless.

On expiry, the payout of the butterfly option will be (Rs 1,000-Rs 980) = Rs 20. Now subtracting
the initial cost of Rs 3.75, the profit will be Rs 16.25 per lot. Further commission and exchange
fees will be deducted to arrive at the actual profit/loss.
But if the trader decides to exit this strategy before expiry, say, when the Reliance Industries
stock is trading around Rs 980 in cash market, and the Call options are trading at 40 (Rs 980), 5
(Rs 1000) and 0.6 (Rs 1020), the payout will be:

Call Option (980) – (40-21.15) = 18.85 (Profit)

Call Option (1000) – 2*(11.30-5) = 12.60 (Profit)

Call Option (1000) – (0.60-5.2) = -4.60 (Loss)

Net Profit & Loss = 26.85 minus commission and exchange taxes

In the above example, when the cash price is equal to the middle strike price, the trader will
earn the maximum profit, but if the cash price is between the high and low strike prices, the
variability of earning profit remains due to trading costs and taxes and there can be a chance
that the trader will incur loss because of high trading cost.

There are various risks to this strategy, which include:

1) Higher implied volatility in case of long butterfly and lower implied volatility in case of short
butterfly

2) Long expiry time as sentiments in the market can change

3) Shorting option in this combination can work in reversal in case of some events related to
security

4) Expiry of out-of-the-money options in case of all Calls or Puts or delivery on expiry date can
work in reverse for this strategy

5) Higher trading costs, commissions and taxes

Long Call/Put Butterfly: This means buying one Call/Put option at higher strike price and one at
lower strike price, and simultaneously selling two Calls/Puts at a strike price near to the cash
price of the same expiry and underlying asset (index, commodity, currency, interest rate). This
strategy involves limited risk, as the maximum amount the trader can lose is the cost of Call/Put
options and it will occur when the cash price trades beyond the range of high and low strike
prices at expiry. The maximum profitability will be when the cash price is equal to the middle
strike price on the expiry day. The breakeven points for this strategy are:

Upper Breakeven Point = Higher strike price long Call/Put option (Strike Price - Premium paid
(Value of option)
Lower Breakeven Point = Lower strike price long Call/Put option (Strike Price + Premium paid
(Value of option)

Short Call/Put Butterfly: This means selling one Call/Put option at higher strike price and one at
lower strike price, and simultaneously buying two Calls/Puts at a strike price near to cash price
of the same underlying asset (index, commodity, currency, interest rates) and of same expiry.
The maximum a trader may lose is the strike price of long Call/Put options and that will occur
when the cash price is at the same level. The maximum profit will be when the cash price is
beyond the range of lower and higher strike prices on the expiry day. The breakeven points of
this strategy are:

Upper Breakeven Point = Higher strike price long Call/Put option (Strike Price - Premium paid
(Value of option)
Lower Breakeven Point = Lower strike price long Call/Put option (Strike Price + Premium paid
(Value of option)
  1 COMMENT

The Black Scholes Model is one of the most important concepts in modern financial theory. The
Black Scholes Model is considered the standard model for valuing options. A model of price
variation over time of financial instruments such as stocks that can, among other things, be used
to determine the price of a European call option. The model assumes that the price of heavily
traded assets follow a geometric Brownian motion with constant drift and volatility. When
applied to a stock option, the model incorporates the constant price variation of the stock, the
time value of money, the option’s strike price and the time to the option’s expiry. Fortunately
one does not have to know calculus to use the Black Scholes model.

Black-Scholes Model Assumptions 

There are several assumptions underlying the Black-Scholes model of calculating options
pricing..

The exact 6 assumptions of the Black-Scholes Model are :

1. Stock pays no dividends.

2. Option can only be exercised upon expiration.
3. Market direction cannot be predicted, hence “Random Walk.”
4. No commissions are charged in the transaction.
5. Interest rates remain constant.
6. Stock returns are normally distributed, thus volatility is constant over time.

These assumptions are combined with the principle that options pricing should provide no
immediate gain to either seller or buyer.

As you can see, many assumptions of the Black-Scholes Model are invalid, resulting in
theoretical values which are not always accurate. Therefore, theoretical values derived from the
Black-Scholes Model are only good as a guide for relative comparison and is not an exact
indication to the over- or underpriced nature of a stock option. 

Limitations of the Black Scholes Model

The Black–Scholes model disagrees with reality in a number of ways, some significant. It is
widely used as a useful approximation, but proper use requires understanding its limitations –
blindly following the model exposes the user to unexpected risk.

Among the most significant limitations are:

1. The Black-Scholes Model assumes that the risk-free rate and the stock’s volatility are constant.
2. The Black-Scholes Model assumes that stock prices are continuous and that large changes (such
as those seen after a merger announcement) don’t occur.
3. The Black-Scholes Model assumes a stock pays no dividends until after expiration.
4. Analysts can only estimate a stock’s volatility instead of directly observing it, as they can for the
other inputs.
5. The Black-Scholes Model tends to overvalue deep out-of-the-money calls and undervalue deep
in-the-money calls.
6. The Black-Scholes Model tends to misprice options that involve high-dividend stocks.

To deal with these limitations, a Black-Scholes variant known as ARCH, Autoregressive

Conditional Heteroskedasticity, was developed. This variant replaces constant volatility with
stochastic (random) volatility. A number of different models have been developed all
incorporating ever more complex models of volatility. However, despite these known limitations,
the classic Black-Scholes model is still the most popular with options traders today due to its
simplicity.
Index Options

An index option is a financial derivative that gives the holder the right, but not the obligation, to
buy or sell the value of an underlying index, such as the Standard and Poor’s (S&P) 500, at the
stated exercise price on or before the expiration date of the option. No actual stocks are bought or
sold; index options are always cash-settled, and are typically European-style options.

Index call and put options are simple and popular tools used by investors, traders and speculators
to profit on the general direction of an underlying index while putting very little capital at risk.
The profit potential for long index call options is unlimited, while the risk is limited to the
premium amount paid for the option, regardless of the index level at expiration. For long index
put options, the risk is also limited to the premium paid, and the potential profit is capped at the
index level, less the premium paid, as the index can never go below zero.

Beyond potentially profiting from general index level movements, index options can be used to
diversify a portfolio when an investor is unwilling to invest directly in the index’s underlying
stocks. Index options can also be used in multiple ways to hedge specific risks in a portfolio.
American-style index options can be exercised at any time before the expiration date, while
European-style index options can only be exercised on the expiration date.

Index Option Examples

Imagine a hypothetical index called Index X, which has a level of 500. Assume an investor
decides to purchase a call option on Index X with a strike price of 505. With index options, the
contract has a multiplier that determines the overall price. Usually the multiplier is 100. If, for
example, this 505 call option is priced at $11, the entire contract costs $1,100, or $11 x 100. It is
important to note the underlying asset in this contract is not any individual stock or set of stocks
but rather the cash level of the index adjusted by the multiplier. In this example, it is $50,000, or
500 x $100. Instead of investing $50,000 in the stocks of the index, an investor can buy the
option at $1,100 and utilize the remaining $48,900 elsewhere.

The risk associated with this trade is limited to $1,100. The break-even point of an index call
option trade is the strike price plus the premium paid. In this example, that is 516, or 505 plus 11.
At any level above 516, this particular trade becomes profitable. If the index level was 530 at
expiration, the owner of this call option would exercise it and receive $2,500 in cash from the
other side of the trade, or (530 – 505) x $100. Less the initial premium paid, this trade results in a
profit of $1,400.
Hedging with Index Options
 AKTUTHEINTACTONE20 MAR 2019 2 COMMENTS

An alternative to selling index futures to hedge a portfolio is to sell index calls while
simultaneously buying an equal number of index puts. Doing so will lock in the value of the
portfolio to guard against any adverse market movements. This strategy is also known as a
protective index collar.

The idea behind the index collar is to finance the purchase of the protective index puts using the
premium collected from selling the index calls. However, as a result of selling the index calls, in
the event that the fund manager’s expectation of a falling market is wrong, his portfolio will not
benefit from the rising market.

Implementation

To hedge a portfolio with index options, we need to first select an index with a high correlation
to the portfolio we wish to protect. For instance, if the portfolio consist of mainly technology
stocks, the Nasdaq Composite Index might be a good fit and if the portfolio is made up of mainly
blue chip companies, then the Dow Jones Industrial Index could be used.

After determining the index to use, we calculate how many put and call contracts to buy and sell
to fully hedge the portfolio using the following formula.

No. Index Options Required = Value of Holding / (Index Level x Contract Multiplier)