Short Call Butterfly

The Short Call Butterfly is an options trading strategy employed by traders who anticipate little to no movement in the underlying asset but want to profit from high volatility in the option prices. This strategy is essentially the reverse of the Long Call Butterfly and aims to capitalize on the decay of option premiums.

The Setup

Imagine a stock, XYZ Corp, which is currently trading at $100. To establish a Short Call Butterfly, you would:

Sell one in-the-money call with a strike price of $95 for $7.
Buy two at-the-money calls with a strike price of $100 for $4 each.
Sell one out-of-the-money call with a strike price of $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 involves selling a call at a lower strike, buying double the amount of calls at a middle strike, and selling a call at a higher strike. The aim is to collect the premiums from the short positions more significantly than what is paid out on the long positions, betting that the stock will close at the middle strike price at expiration.

Breakeven Process

The breakeven points are calculated by considering 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 perfect scenario for a Short Call Butterfly occurs when the stock price finishes exactly at the middle strike price at expiration ($100). This outcome means the long calls expire worthless while the trader keeps the full premium from the short calls.

Max Profit Potential

The maximum profit for a Short Call Butterfly occurs if 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 limited and occurs if the stock price moves significantly beyond either the lowest or highest strike prices. The loss is essentially the net debit paid ($1 per share), plus any additional costs incurred in setting up the positions.

Risk

The primary risk of a Short Call Butterfly is that the stock price moves significantly away from the middle strike price. However, this risk is capped at the amount of the net debit paid to establish 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 favorable, as it inflates the premiums of the at-the-money options which are bought. If volatility decreases, it can lead to a reduction in the price of these options, increasing the overall profitability of the trade.

Conclusion

A Short Call Butterfly is a complex strategy best used by experienced traders who can predict stability in the stock price and capitalize on changes in implied volatility. It offers defined risk, with potential gains maximized if the stock price finishes exactly at the middle strike at expiration