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Sunday, July 15, 2001












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Option Basics -- VIII

Butterfly tactics

Anup Menon

ASSUME you are an investor and you want to take a view on the volatility of the stock of say ABC company. Further assume that you are sure that either the volatility of the stock will increase or that the volatility of the stock will decrease. In such circumstances, an investor can consider using a butterfly spread to profit and at the same time have a limited risk exposure. Buying a butterfly would yield a profit when volatility is expected to come down and selling a butterfly would result in a profit when volatility is expected to go up.

A butterfly strategy requires three distinct transactions. For instance, in the case of a long butterfly, investors have to buy two options with different strike prices and sell two options on the strike price which is the middle of the ones that have been bought.

Therefore, if the investor buys options with strike prices of 50 and 60 respectively, he has to sell options with a strike of 55. The reverse strategy is applicable for a short butterfly. A butterfly is by definition "contract-neutral". This means that the number of contracts bought should be equal to the number of contracts sold.

Say that you create a long butterfly by buying two options with strike prices fixed at Rs 90 and Rs 110 respectively. At the same time you have to sell two options with the strike price of Rs 100. Assume for the moment that the premiums paid for the options purchased is worth Rs 15 and the premiums received on the sale of the options is Rs 10. Therefore, the net cost for the investor is the difference in premium which is equal to Rs 5.

At maturity, the maximum loss that can be suffered by the investor is the net difference in premium which is equal to Rs 5. For instance, the price of the asset closes at Rs 115. Then what happens? Both the options that the investor has bought will be in the money and it will give him a net gain of Rs 30 (25+5). However, remember that he has also written options at Rs 100.

Therefore, his loss is equal to two times the loss of Rs 15 each per option. Therefore the net loss is Rs 30. This implies since the options cancel out each other, the maximum loss for the investor is always the premium paid.

Now the question is when are his profits maximum? His profits are maximum if the stock closes at the strike on which the investor has sold options. For instance consider what happens when the stock closes at Rs 100. The option he bought for Rs 90 will give him a net gain of Rs 10. The other option that he has bought at Rs 110 is worthless. What will happen to the options that have been written.

These options also will not be exercised as the option buyer would not be able to cover even a fraction of the premium paid. Therefore, the contract that have been written will also not be exercised. This means that the maximum possible gain for the investor from this strategy would be Rs 10.


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