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Butterfly spread using calls
Butterfly spread is a good strategy when there is not volatility. This strategy also has self protection against big moves. However this can also produce limited amount of loses when market makes big moves. This strategy can be executed with calls and puts.First let me take the execution of the butterfly spread using calls.
In this case the strategist sells two calls at 25 strike price on MSFT and at the same time buys one call at 21 strike and another at 29 strike. Since the spot price of MSFT is $25, the call at 21strike price is deep in the money and call at 29 strike price is deep out of the money. Intrinsic value of a call at 21strike price is $4. With time value added this call will have a premium above $6 at the beginning of a new series. Call at 29 strike price will have a premium of $0.5. Therefore the strategist will be paying $6.5 for the calls he bought. He will be receiving $4 for two calls he sold at 25 strike price. It should be noted that the strategist is a net payer to the exchange and hence this spread is a debit spread. No margin is therefore required.
If MSFT closes at 29 on the date of expiration, his call at 21 strike price will give him a profit of $2. The calls sold at strike price 25 will produce a loss of $4(8-4). Call bought at strike price 29 will expire worthless giving him an additional loss of $0.5. Therefore his maximum loss if MSFT closes above 29 on the date of expiration is $2.5. In the case of MSFT closing at 21 on the date of expiration his calls bought at 21 strike price and 29 strike price expires worthless giving him a loss of $6.5. Similarly the calls sold at 25 strike price will also expire providing him with a profit of $4. Thus his maximum loss if MSFT closes below 21 is $2.50. His maximum profit comes when MSFT closes at 25 on expiry date. In that case his call bought at 21 will give him a loss of $2(6-4). His call bought at 29strike price expires worthless giving a loss of $0.5. But he gets the premium on 25 strike price free because MSFT closes at 25.Therefore maximum profit he gets is $1.5. For 10 contracts on MSFT his maximum profit will be $1500 and maximum loss $2500. This is not a good risk reward ratio.
There is another defect for this strategy. Since call at 21 strike price is deep in the money its delta is 1. If the share price goes up its delta remains the same. Call at 29 strike price is far out of the money. Therefore its delta is very small. Therefore it will not move up much even if MSFT goes up above 25.
But consider the delta of 25 strike price calls. When MSFT is trading at 25, its delta is 0.50. If MSFT goes up its delta starts increasing because it is becoming more in the money. Since there are two calls sold at 25strike price, cumulative increase in premiums on them will be much more than the premium on call at strike 20. Premium on call at 29 remains static because its delta is very small.
This results in a situation where the strategist finds himself stuck with this positions till expiration if MSFT moves up above 25. It will become difficult to get out of the positions with moderate profit, if MSFT is above 25. Therefore the strategist is left to a chance of MSFT closing near 25 at expiration. The probability for the same is very low.
A similar situation arises when MSFT trades below 25. Call at 20 strike price has a delta of 1 and is deep in the money. Therefore when MSFT trades below 25 ,its delta remains nearly one and premium goes down faster than 25 strike price calls. In fact delta of 25 strike calls starts going down because they are becoming out of the money. Hence premium on 25 strike price calls will not diminish much as the share price goes down. This also creates a situation in which the strategist is forced to hold the position till expiration. His chances of MSFT closing near 25 are very low.
Considering the risk reward ratio and the low probability of getting any profit, this strategy is not very useful in the practical situation.
Therefore this strategy also is not advised.
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com