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Short Call Butterfly Option Strategy

Short Call Butterfly Option Strategy

What is Short Call Butterfly Option Strategy?

  • Short Call Butterfly is a three-leg options strategy created by selling an ITM call options buying 2 ATM call options and selling an OTM option trading. All call has the same expiration and strikes should be equidistant. In Short Call Butterfly trader expects market to show significant move either side. Short Call butterfly establish as net credit strategy which has limited profit potential and limited risk. Short call butterfly will benefit from the increase in the volatility. To achieve the maximum benefit, underlying, like Nifty/BankNifty/FinNifty or F&O stocks must move below the lower strike price or rise above the higher strike price. Volatility is of foremost importance for the significant move. Higher the volatility higher probability of stock to move significantly

When to Short Call Butterfly Execute?

  • Short Call Butterfly can be executed when. Expecting a significant move either side, where your maximum profit occurs if the stock moves significantly up or down, profit is limited on both sides. It is an ideal strategy, when one is anticipating very high volatility in the stock price. Short call option butterfly should never be deployed when stock is directional, either bullish or bearish, we should have a market forecast as either side, while Volatility plays its major role.

What is the Trade?

  • Short Call Butterfly can be devised by selling One lot In-the-Money (ITM) Call, buying 2 lots At-the-Money (ATM) Calls, and selling 1 lot Out-of-Money (OTM)Call of the same underlying and expiration, while the difference between the strike price should be equal i.e. the trader should select the strikes with are equidistant from ATM. Short Call option Butterfly should not be devised based on moderately bullish and bearish biasness by shifting the spread completely to the OTM or ITM side respectively.

Break-Even Point for Short Call Butterfly

  • There will be two breakeven in this Short Call Butterfly Options.
    The lowest breakeven point for short call butterfly is when underlying price is equals the lower strike plus net credit. (ITM CE + Net Credit).
    The Higher Breakeven point for short call option butterfly is when underlying price is equal the higher strike price minus net credit.

What will be maximum profit?

  • Short Call Butterfly Options achieves the maximum profit when underlying price expires on the either of the wings of butterfly i.e. if it closes above or below the break even point short call butterfly will realised the maximum profit.
    Profit condition in short call option trading will be achieved by following conditions.
    1. If underlying closes on lower wing of the butterfly, then Short Call Butterfly will expire worthless i.e., all the options will become zero. So, trader will keep the net credit.
    2. If underlying closes on the higher wing of butterfly, then Short Call Butterly will expire ITM i.e all the options will have some intrinsic value, which will make net value of butterfly zero, so trade will keep the net credit again.

What will be maximum loss?

  • Maximum Loss occur in Short Call butterfly when underlying fails to show the significant movement it expires around the ATM option. In this case as we bought two options, sold option will fails to compensate for it and trade will incur max at loss at the tip of the butterfly. Which can easily be calculated by subtracting ATM strike - ITM strike and adjusted for initial net credit.

What are the advantages?

  • Short call butterfly is good for the stock which is oscillating for long time and having an important event down the line, which creates the uncertainty for the stock and it is expected to move either side because of increase in the volatility. Short Call Butterfly is a net credit strategy with defined reward to risk.
    Another advantage is that this option trading strategy requires the trader to have a less amount of capital to invest, as it involves buying and selling multiple option contracts.

What are the disadvantages?

  • One disadvantage of the Short call butterfly strategy is that it has limited profit potential.
    Another disadvantage is that the strategy has a relatively high breakeven point, meaning that the underlying asset would need to move a significant amount before the trader begins to make a profit.
    Additionally, this strategy is sensitive to changes in volatility, meaning that if volatility decreases, the value of the options will decrease, which can lead to losses for the trader.
    Finally, like other options strategies, the short call butterfly strategy also has a limited lifespan, as options expire at a certain date, so the trader needs to be aware of that expiration date and close the position before it expires.

Example for Short Call Butterfly:

  • Nifty future price is 17950. A Short Call Butterfly can be devised by Buying two lot of 17950 CE (ATM) at Rs.156.60 and selling one lot of 17700 CE (ITM) at Rs.311.80 and 18200 CE at 61.10 respectively. Net Premium Paid or Received = Rs. (+59.7). Maximum profit will if underlying above or below the upper or lower sold strike price i.e.,17760 and 18140. Max Loss if underlying i.e., at 17950.

Impact of Delta on Short Call Butterfly:

  • The impact of delta on a short call butterfly option trading strategy is that a change in the underlying asset's price will affect the value of the options in the position differently. The call options that are sold (short) will have a negative delta, meaning that as the underlying asset's price increases, the value of the short call options will decrease. The call options that are bought (long) will have a positive delta, meaning that as the underlying asset's price increases, the value of the long call options will increase. This creates a butterfly shape in the position's delta profile.

    If the underlying price is lowest strike price in a short call butterfly, then the net delta is slightly negative. If the is trading above the highest strike price, then the net delta is slightly positive. Overall, a Short Call Option Butterfly profits from a stock price rise above the highest strike price or a fall below the lowest strike price.

Impact of Time on Short Call Butterfly

  • A short call butterfly has a net negative theta if the underlying is option trading between the higher strike price and lower strike price. If the stock price moves out of this range, however, the theta becomes positive as expiration approaches.

Impact of Vega on Short Call Butterfly:

  • The impact of Vega on a short call butterfly option strategy is that it can affect the value of the options in the position differently. Vega is a measure of an option's sensitivity to changes in implied volatility. A short call butterfly position generally has a positive Vega, which means that as implied volatility increases, the value of the position will increase.

    An increase in implied volatility will increase the value of both short call options and long call options, but the short call options will increase more in value than the long call options. This creates a Vega imbalance in the position, with the short options being more sensitive to changes in implied volatility than the long options.

    Therefore, when implied volatility is high, the short call butterfly will be more profitable. Conversely, when implied volatility is low, the short call butterfly will be less profitable. It's important for investors to be aware of the impact of Vega on a short call butterfly option trading strategy and to adjust their positions accordingly.