https://medium.com/@gyvishwanath/butterfly-strategy-5eab2d8d5668
Course Relevance
This caselet is designed for the following PGDM / MBA courses:
- Financial Derivatives : applies option concepts to futures, forwards and swaps and option strategies.. How options can be used to make riskless profits?
Academic Concepts
- This caselet draws on multiple applications of finance knowledge in avoiding and identifying risk in financial market and option markets.
- It talks about the risk of manipulation of option prices.
- It discusses risk management
- It talks about due diligence
A Butterfly Strategy is a neutral options trading strategy used when an investor of options expects the price of an underlying asset to remain relatively stable until the expiration date and predicts a known outcome. It combines both limited risk and limited profit potential, making it suitable for traders who anticipate low volatility in the market and sometimes even during high volatility with proper risk management.
The strategy derives its name from the shape of its payoff diagram, which resembles a butterfly with two buys and two sells of calls.
Why use a Butterfly Strategy?
When You want to make a profit if the underlying asset sticks close to a certain price and you’re looking for ways to take advantage of quiet, low-volatility markets.This is suitable when you want to lock in your risk, and you’re okay with capping your reward too and without undue tension. Then you need an options strategy that won’t break the bank, you go for Butterfly strategy.
How do you build a Long Call Butterfly from the option lines?
Here’s what you do when a line of option prices are available for different strike prices.
1. Buy one call option at a lower strike price (K1).
2. Sell two call options at a middle strike price (K2).
3. Buy one call option at a higher strike price (K3).
Just make sure K1 is less than K2, and K2 is less than K3. Usually, the strike prices are spaced out evenly. That’s what gives the butterfly its shape.K1 < K2 < K3
Example
Suppose the index(nifty) is trading at ₹24000.
| Position | Strike Price | Premium (₹) |
| Buy 1 Call | 24100 at | 65 |
| Sell 2 Calls | 24000 at | 100 |
| Buy 1 Call | 23900 at | 140 |
Net Premium Paid:
= 65-140-200
= Rs.5
Thus, the maximum loss is limited to ₹5 per share. Hence, if you trade in nifty with a market lot of 65 your maximum loss would be Rs.330 only.
Payoff Analysis
Maximum Profit
Occurs when the stock price equals the middle strike price (₹24000) at expiration.
Maximum Profit:
= Difference between adjacent strike prices − Net Premium Paid
Maximum Profit=(K2−K1)−Net Premium\text{Maximum Profit}=(K_2-K_1)-\text{Net Premium}Maximum Profit=(K2−K1)−Net Premium
For the example:
= 200-40-65 = 95
= ₹95 per 1 index
Maximum Loss
Occurs when the stock price is at or below ₹23900 or at or above ₹24100.
Maximum Loss = Net Premium Paid
= ₹5 per share
Break-even Points
Lower Break-even:
Lower B/E=K1+Net Premium\text{Lower B/E}=K_1+\text{Net Premium}Lower B/E=K1+Net Premium
= 23900 +5 = ₹23905
Upper Break-even:
Upper B/E=K3−Net Premium\text{Upper B/E}=K_3-\text{Net Premium}Upper B/E=K3−Net Premium
= 24100 − 5 = ₹20095
Advantages
- Limited Risk – Maximum loss is known in advance.
- Low Cost – Requires a relatively small initial investment.
- Suitable for Range-Bound Markets.
- Good Risk-Reward Ratio when volatility is expected to remain low.
- Less capital intensive than many directional strategies.
Disadvantages
- Limited Profit Potential.
- Requires accurate prediction of the expected price range.
- Time decay can affect profitability if the market moves unexpectedly.
- Transaction costs may reduce returns due to multiple option positions.
Types of Butterfly Strategies
1. Long Call Butterfly
Uses only call options and benefits from low volatility. For example call options of nifty and sensex.
2. Long Put Butterfly
Uses put options instead of calls but produces a similar payoff. For example put options of nifty and sensex.
3. Short Butterfly
The opposite position of a long butterfly. It profits from high volatility and significant price movements.Instead of buying we will sell and vice versa.
4. Iron Butterfly
Constructed using both call and put options. It generally provides a net credit and is widely used by professional traders. It can be applied to both stocks and indices.
Practical Applications
- When traders expect the market to remain stable.
- Before events where volatility is expected to decline after announcements.
- In index options such as NIFTY 50 and SENSEX when a range-bound movement is anticipated.
- For income generation with controlled risk.
Conclusion
The Butterfly Strategy is a sophisticated yet relatively low-risk options strategy designed for markets expected to exhibit little price movement or so called flat market with minimum variations. It offers limited risk and limited reward, making it attractive to conservative options traders of equity and index options and with limited margins. By carefully selecting strike prices and expiration dates, traders can profit when the underlying asset closes near the middle strike price at expiry with a certain precision with the confidence that the loss would not exceed a small limit and an opportunity for a decent profit It is particularly useful in low-volatility environments and is widely employed in professional options trading and portfolio management by traders and investors who have huge capital as the margins required for options trading is high though for index options due to hedging margins may come down..
Teaching Note :
This topic is relevant for the security analysis,nternational Finance and derivatives course studied by the PGDM2 students. This covers what is a butterfly and how to identify profit opportunities and prevent risk. As we have discussed this knowledge will help in reducing the risk and making use of opportunities.
Learning Objectives
After engaging with this caselet, students will be able to:
- Analyze how butterfly strategy works
- Apply risk management concepts in real markets
- Evaluate the risk and return of strategies.
Key Discussion Points
- Importance of option strategies
- How to reduce margin requirements and how to educate investors in identifying opportunities.
Discussion Questions :
- Do you think the this strategy will work? Give your reasons.
- What are derivatives? Explain the economic necessity of derivatives trading.
References :
- Fama, Eugene F, Lawrence Fisher, Michael C, Jensen, and Richard Roll (1969). “The Adjustment of stock prices to New Information.” International Economic Review,10(1), 1-21.
- Figlewski, S. (1984). “Hedging Performance and Basis Risk in Stock Index Futures.” The Journal of Finance, 39(3), 657-669.
3. Grant, D. (1982). “Market Index Futures Contract and Portfolio Selection.” Journal of conomics and Business, 34(14), 387-390.
4.Madhumathi. R & Ranganatham. M (2012).
“Derivatives and Risk Management.”
