Short butterfly
| Range | Value |
|---|---|
Market expectation | Rising volatility |
Construction | Call short with strike price E1 |
Profit potential | Limited |
Risk of loss | Limited |
Time effect | ? |
Volatility effect | Neutral |
Market expectation
The short butterfly is a good choice if you expect strong price changes, which is accompanied by rising volatility. The average strike price should be at the current price level of the underlying.
Construction
Calls with three different strike prices are required to construct a short butterfly with calls. You buy two calls at the middle strike price and sell the two calls at the outer strike prices.
Alternatively, the short butterfly could also be interpreted as the simultaneous conclusion of a bear price spread (call short with E1 and call long with E2) and a bull price spread (call long with E2 and call short with E3).
You can also build a short butterfly with puts, which leads to a similar profit and loss curve and therefore does not need to be described separately.
Profit potential
The profit potential is limited. The short butterfly has a maximum profit in the amount of the (net) premium received. You realize the maximum profit if the price of the underlying is below E1 and above E3 at maturity.
The lower break-even point is the sum of the lower base price E1 plus (net) premium expense, the upper break-even point at the upper base price E3 minus (net) premium expense.
When considering the profit potential, bear in mind the high transaction costs, which have a decisive influence in practice, especially for small contract volumes.
Risk of loss
The risk of loss of the short butterfly is limited. The maximum loss is incurred if the price of the underlying asset is quoted exactly at the strike price E2 at maturity. It corresponds to the difference between the base prices E2 and E1 offset against the (net) premium for the position.
Time effect
If the price of the underlying does not change, there is a negative fair value effect. The long calls are then "at-the-money" with a high time value loss, the other two are far "in-the-money" or far "out-of-the-money".
The time effect becomes slightly positive if the price is below E1 or above E3, as a call short is then "at-the-money" and its effect dominates.
Volatility effect
The volatility effect is neutral due to the design. However, rising volatility has a positive effect by increasing the probability of price changes.