Short Call Butterfly

The Short Call Butterfly Setup

Imagine you have a stock, XYZ Corp. It is trading at $100. You want to set up a Short Call Butterfly, you would:

• Sell one in-the-money call at $95 for $7.
• Buy two at-the-money calls at $100 for $4 each.
• Sell one out-of-the-money call at $105 for $2.

All options have the same expiration date. This setup results in a net debit of $1 ($8 received - $8 paid).

Who Should Consider It

This strategy is ideal for traders who expect the stock to remain near the middle strike price with minimal fluctuation. It’s particularly appealing in environments where high volatility increases the premium of at-the-money options, which are the core of this strategy.

Strategy Explained

The Short Call Butterfly consists of selling a call at a lower strike, buying double the number of calls at a middle strike and selling a call at a higher strike. The goal is to collect more in premiums from the short positions than what is paid out on the long positions, basing the speculation that the stock will close at the middle strike price at expiration.

Breakeven Process

The breakeven points consider the total net debit or credit and the range of the strike prices.

• Upper breakeven: Middle strike price + net debit = $100 + $1 = $101.
• Lower breakeven: Middle strike price - net debit = $100 - $1 = $99.

Sweet Spot

The ideal case for a Short Call Butterfly is when the stock price expires exactly at the middle strike price, which is $100. It means that all the long calls expire worthless, and the trader gets to retain the full premium from the short calls.

Max Profit Potential

The maximum profit for a Short Call Butterfly is when the stock price is at the middle strike at expiration. The profit is the difference between the premiums of the short calls and the cost of the long calls minus the net setup cost, which can be minimal if set up as a net credit.

Max Loss

The maximum loss is capped, and this comes into play whenever the stock moves sufficiently away in either direction against the lowest and highest strike price. Loss-Net debit amount paid out to enter ($1 per share)+additional costs related to establishing both positions.

Risk

The most significant risk for a Short Call Butterfly is the stock price’s movement beyond the middle strike. However, such risk is always capped by the amount of net debit paid in establishing the spread.

Time Decay

Time decay (theta) is beneficial to this strategy if the stock remains near the middle strike price. As expiration approaches, the value of the long at-the-money options decays, potentially increasing the profitability of the short positions.

Implied Volatility

High implied volatility at the entry of the trade is beneficial as it inflates the premiums of the at-the-money options bought. In case the volatility decreases, it may reduce the price of these options and hence increase the overall profitability of the trade.

Conclusion

A Short Call Butterfly is a more complex strategy best reserved for experienced traders who can confidently predict some stability in the stock price and leverage on changes in implied volatility. It has defined risk, with maximum potential gains if the stock price finishes precisely at the middle strike at expiration.