Today's article will teach us about the short-call butterfly options strategy. This strategy has been the favorite among those with a low-risk appetite, as it offers limited risk and limited profit.
When to implement this strategy?
This strategy is best suitable when you can see high volatility in the market. This high volatility can be due to the elections, budget policy, some announcements, etc. It can also be implemented when you know the market will be highly volatile but are not sure about the direction of the movement.
How to enter the short call butterfly option strategy?
This strategy has two long calls at at-the-money and one short call option, each at a lower and upper strike price. All the option contracts must be of the same underlying asset and have the same expiry dates. The upper and lower strikes should be equidistant from the at-the-money option contract.
This strategy involves selling 1 in-the-money call option, purchasing 2 at-the-money call options, and selling 1 out-of-the-money call option.
Sell 1 ITM call option contract.
Buy 2 ATM call option contracts.
Sell 1 OTM call option contract.
Break Even points of short call butterfly:
The short call butterfly has the two breakeven points as below:
Lower breakeven point = lower strike price + Total premium.
Upper breakeven point = higher strike price - Total premium.
Highest profit on the strategy:
As we said, it is a limited risk and limited reward strategy. Profit will be capped to the net premium received when the stock price closes beyond the range of strike prices at the time of expiry.
Advantages of using this strategy:
The short call butterfly does not require investment, as traders will receive the premium. It helps you to exploit the highly volatile market and profit from it. You do not have to speculate your trade based on the direction of the movement.
How to exit from the short call butterfly strategy?
In order to exit from the strategy, you can reverse the position, sell what you bought and buy back those options which you sold.
Illustration
Eg. Nifty is currently trading @ 5500. Selling Call Option of Nifty having Strike 5400 @ premium 200, Strike 5600 @ premium 80 and Buying 2 lots of Call Option of Nifty having Strike 5500 @ premium 130 will help the investor benefit if Nifty on expiry stays below 5400 or above 5600.
Strategy | Stock/Index | Type | Strike | Premium Inflow |
Short Call Butterfly | NIFTY (Lot size 50) | Sell Call | 5400 | 200 (Inflow) |
| | Buy Call - 2 Lots | 5500 | 130 (Outflow) |
| | Sell Call | 5600 | 80 (Inflow) |
The Payoff Schedule and Chart for the above is below.
Payoff Schedule
NIFTY @Expiry | Net Payoff (Rs.) |
5100 | 1000 |
5200 | 1000 |
5300 | 1000 |
5400 | 1000 |
5420 | 0 |
5500 | -4000 |
5580 | 0 |
5600 | 1000 |
5700 | 1000 |
5800 | 1000 |
5900 | 1000 |
In the above chart, the breakeven happens the moment Nifty crosses 5420 or 5580. The reward is limited to 1000 (calculated as Net premium received * Lot Size). The risk is limited to 4000 [calculated as (Difference in strike prices - net premium received) * Lot Size].
Note: Similar strategy can be constructed using Put Options as well