Short Call Butterfly: Limited Risk Option Trading Strategy

How to Trade the Short Call Butterfly?

Trading the short call butterfly involves selling and purchasing options. The strategy gets the name as the payoff graph resembles a butterfly. Similar to a butterfly, the strategy has a main body and two wings.

Here’s how you can trade the short call butterfly.

•       Sell one in-the-money (ITM) call option (CE).
•       Buy two at-the-money (ATM) call options.
•       Sell one out-of-the-money (OTM) call option.

It is important to note that the sold and bought options should be of the same expiry and the same underlying.

The trade is undertaken with the expectation of a rise in volatility and a move in either direction. The trade profits from the net premium received while the maximum loss only occurs if the underlying expires at the middle strike price. The strategy breaks even at the upper or lower sold call strike prices along with the net premium received.

Let’s explore the strategy further with the help of an example:

A trader expects Stock ABC to make a moderate move in either direction and deploy a short call butterfly.

•       Stock ABC is trading at Rs 500.
•       Sell 1 lot of 480 CE (ITM) – Premium received = Rs 450
•       Buy 2 lots of 500 CE (ATM) – Premium paid = 250x2 = Rs 500
•       Sell 1 lot of 520 CE (OTM) – Premium received = Rs 150
•       Net Premium = (450+150) – 500 = Rs 100.

If ABC’s price falls to Rs.450 on expiry, the trade’s profit would be the net premium received. Since the stock price declined, the ATM call options will expire worthless in addition to both the sold call options. The premium received from the sold call options will offset the loss of the bought call options.

If ABC’s price rises to Rs 550, the sold call options will see a rise in premium resulting in a loss. However, the premiums from the bought call options will increase as well and offset the losses. As a result, the net payoff will be the net premium received.

The maximum loss of the strategy takes place if ABC’s price on expiry is at the middle strike price, Rs 500. In this case, the difference between the lowest and middle strike price minus the net premium received becomes the net loss.

The strategy would break even at two points. If ABC’s price falls to Rs 490 or rises to Rs 510. The breakeven scenario happens when the stock price is not below the lowest sold strike price or above the highest sold strike price.

Impact of Options Greeks

Options Greeks play a crucial role in the way premiums react which in turn has an impact on options trading strategies.

Delta: Delta calculates how much the option price will change with a directional change in the underlying asset. The delta of the short-call butterfly will remain close to zero.

Vega: Implied volatility (IV) is an important part of the short call butterfly. Vega is used to measure the change in the price of an options contract for a percentage change in the IV. For example, if the vega of an option is higher, a percentage change in the IV will result in a larger change in price of the option. This is an important Greek as the short call butterfly is deployed usually when a trader expects a rise in IV.

Theta: Option premiums erode as expiry approaches, and Theta, or Theta decay is an important aspect of option trading strategies. If the price of the underlying does not move, the Theta will have a negative impact on the strategy.

Conclusion

The short call butterfly strategy offers traders limited downside and limited returns. The strategy is useful when one expects the market to make a move in either direction. As a result, a trader can even benefit in volatile markets. However, it is important to manage risk and make informed decisions while executing complex strategies like the short call butterfly.