Nilesh Jain11th December 2022
217.9kViews
A Short Call Butterfly is implemented when an investor is expecting volatility in the underlying assets. This strategy is initiated to capture the movement outside the wings of the options at expiration. It is a limited risk and a limited reward strategy.
When to initiate a Short Call Butterfly?
Short Call Butterfly can generate returns when the price of an underlying security moves moderately in either direction. It means that you don’t have to forecast the trend of the market, but you have to bet on volatility. When the implied volatility of the underlying assets is low and you expect volatility to shoot up, then you can apply Short Butterfly Strategy.
How to construct a Short Call Butterfly?
A Short Call Butterfly can be created by selling 1 ITM call, buying 2 ATM call and selling 1 OTM call of the same underlying security with the same expiry, giving the trader a net credit to enter the position. Strike price can be customized as per convenience of the trader but the upper and lower strikes must be equidistant from the middle strike.
| Strategy | Sell 1 ITM Call, Buy 2 ATM Call and Sell 1 OTM Call |
| Market Outlook | Movement on or above the sold strike price & Bullish on volatility |
| Motive | Attempt to correctly predict the movement in underlying assets in either direction |
| Upper Breakeven | Higher Strike price of short call Net Premium Received |
| Lower Breakeven | Lower Strike price of short call + Net Premium Received |
| Risk | Limited (Maximum loss only if expires at middle strike) |
| Reward | Limited to Net premium received |
| Margin required | Yes |
Let’s try to understand with an Example:
| Nifty Current spot price (Rs) | 8800 |
| Sell 1 ITM call of strike price (Rs) | 8700 |
| Premium received (Rs) | 210 |
| Buy 2 ATM call of strike price (Rs) | 8800 |
| Premium paid (Rs) | 300(150*2) |
| Sell 1 OTM call of strike price (Rs) | 8900 |
| Premium received (Rs) | 105 |
| Upper breakeven | 8885 |
| Lower breakeven | 8715 |
| Lot Size | 75 |
| Net premium received (Rs) | 15 |
Suppose Nifty is trading at 8800. An investor Mr A enters a Short Call Butterfly by selling 8700 call strike price at Rs 210 and 8900 call for Rs 105 and simultaneously bought 2 ATM call strike price of 8800 @150 each. The net premium received to initiate this trade is Rs 15, which is also the maximum possible reward. This strategy is initiated with a view of moderate movement in Nifty hence it will give the maximum profit only when there is movement in the underlying security either below lower sold strike or above upper sold strike. Maximum loss from the above example would be Rs 6375 (85*75) if it expires at middle strike. The maximum profit would only occur when underlying assets expires below 8700 or above 8900 i.e. Rs 1125 (15*75). Another way by which this strategy can give profit is when there is an increase in an implied volatility. For the ease of understanding, we did not take in to account commission charges. Following is the payoff chart and payoff schedule assuming different scenarios of expiry.
The Payoff Chart:
The Payoff Schedule:
| On Expiry NIFTY closes at | Net Payoff from 1 ITM Call Bought (Rs.) | Net Payoff from 2 ATM Calls Sold (Rs.) | Net Payoff from 1 OTM Call Bought (Rs.) | Net Payoff (Rs.) |
| 8200 | 210 | -300 | 105 | 15 |
| 8300 | 210 | -300 | 105 | 15 |
| 8400 | 210 | -300 | 105 | 15 |
| 8500 | 210 | -300 | 105 | 15 |
| 8600 | 210 | -300 | 105 | 15 |
| 8700 | 210 | -300 | 105 | 15 |
| 8715 | 195 | -300 | 105 | 0 |
| 8800 | 110 | -300 | 105 | -85 |
| 8885 | 25 | -130 | 105 | 0 |
| 8900 | 10 | -100 | 105 | 15 |
| 9000 | -90 | 100 | 5 | 15 |
| 9100 | -190 | 300 | -95 | 15 |
| 9200 | -290 | 500 | -195 | 15 |
| 9300 | -390 | 700 | -295 | 15 |
| 9400 | -490 | 900 | -395 | 15 |
Impact of Options Greeks before expiry:
Delta: The net delta of a Short Call Butterfly spread remains close to zero.
Vega: The Short Call Butterfly has a positive Vega. Therefore, one should buy Short Call Butterfly spread when the volatility is low and expect to rise.
Theta: With the passage of time, if other factors remain same, “Theta” will have a negative impact on the strategy, because option premium will erode as the expiration dates draws nearer.
Gamma: The Short Call Butterfly will have a short gamma when it is initiated.
How to manage risk?
A Short Call Butterfly requires experience in trading, because as expiration approaches small movement in underlying stock price can have a higher impact on the price of a Short Call Butterfly spread. Therefore, one should always follow strict stop loss in order to restrict losses.
Analysis of Short Call Butterfly spread strategy
A Short Call Butterfly spread is best to use when you are confident that an underlying security will move in either direction. This is a limited reward to risk ratio strategy for advance traders.
