Short Call Butterfly

Short Call Butterfly

Post By - Laxmi Mahera
Review By : Rohan Sharma
Updated on : October 26, 2021

Basics Concepts – Short Call Butterfly

Description - Short Call Butterfly

The Short Call Butterfly is another volatility strategy and is the opposite of a Long.
Call Butterfly, which is a range bound strategy.
The Short Call Butterfly involves a low strike short call, two ATM long calls, and an OTM short call.
The resulting position is profitable in the event of a big move by the stock.
The problem is that the reward is seriously capped and is typically dwarfed by the potential risk if the stock fails to move.
All options share the same expiration date for this strategy.
For this strategy, you must use all calls.
Remember that there should be equal distance between each strike price.
The maximum risk occurs if the stock is at the middle strike at expiration.
Sell one lower strike (ITM) call.
Buy two middle strike (ATM) calls.
Sell one higher strike (OTM) call.

Introduction to Short Call Butterfly

Outlook

With Short Call Butterfly, your outlook is direction neutral. You are looking for increasing volatility with the stock price moving explosively in either direction.

Rationale

With short butterflies, you are looking to execute a limited yielding trade at a net credit whereby your maximum profits occur if the stock finishes on either side of the upper and lower strike prices at expiration.
You are anticipating high volatility with the stock price, which will lead you to profit.

Net Position

This is a net credit trade.
Your maximum risk is the difference between the adjacent strike prices less the net credit.
Remember that the upper and lower strike prices are equidistant to the middle strike price.
Your maximum reward is the net credit you receive.

Effect of Time Decay

Time decay is generally harmful to your trade here because you are looking for a lot of movement in the stock price. After the position has become profitable, time decay becomes helpful.

Time Period to Trade

At least three months out.

Breakeven Down = [Lower strike + net credit]

Breakeven Up = [Higher strike – net credit]

Steps to Trading a Short Call Butterfly

Steps In

Actively seek chart patterns that appear like pennant formations, signifying a consolidating price pattern.

Steps Out

Manage your position according to the rules defined in your Trading Plan.
You can unravel the position just before expiration — remember to include all the commissions in your
calculations.

Exiting the trade - Short Call Butterfly

Exiting the Position

With this strategy, you can simply unravel the spread by buying back the options you sold and selling the options you bought in the first place.
Advanced traders may leg up and down or only partially unravel the spread as the underlying asset fluctuates up and down.

Mitigating a Loss

Unravel the trade as described previously.
Advanced traders may choose to only partially unravel the spread leg-by-leg and create alternative risk profiles.

Advantages and Disadvantages

Advantages

Profit from a range bound stock with no capital outlay.
Capped risk.
Comparatively high profit probability if the stock moves explosively.

Disadvantages

The higher profit potential comes with a wider range between the strikes.
The higher profit potential only comes nearer expiration.
The potential loss is far greater than the amount by which you can profit.
Bid/Ask Spread can adversely affect the quality of the trade.

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