36 lines
2.7 KiB
Plaintext
36 lines
2.7 KiB
Plaintext
Chapter 10: The Butterfly Spread 203
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Note that all of these answers agree with the results that were previously obtained by
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analyzing the example spread in detail.
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In this example, the maximum profit potential is $700, the maximum risk is
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$300, and the investment required is also $300, commissions excluded. In percent
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age terms, this means that the butterfly spread has a loss limited to about 100% of
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capital invested and could make profits of nearly 133% in this case. These represent
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an attractive risk/reward relationship. This is, however, just an example, and two fac
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tors that exist in the actual marketplace may greatly affect these numbers. First, com
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missions are large; it is possible that eight commissions might have to be paid to
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establish and liquidate the spread. Second, depending on the level of premiums to
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be found in the market at any point in time, it may not be possible to establish a
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spread for a debit as low as 3 points when the strikes are 10 points apart.
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SELECTING THE SPREAD
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Ideally, one would want to establish a butterfly spread at as small of a debit as pos
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sible in order to limit his risk to a small amount, although that risk is still equal to
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100% of the dollars invested in the spread. One would also like to have the stock be
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near the middle striking price to begin with, because he will then be in his maximum
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profit area if the stock remains relatively unchanged. Unfortunately, it is difficult to
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satisfy both conditions simultaneously.
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The smallest-debit butterfly spreads are those in which the stock is some dis
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tance away from the middle striking price. To see this, note that if the stock were
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well above the middle strike and all the options were at parity, the net debit would
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be zero. Although no one would attempt to establish a butterfly spread with parity
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options because of the risk of early assignment, it may be somewhat useful to try to
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obtain a small debit by taking an opinion on the underlying stock. For example, if
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the stock is close to the higher striking price, the debit would be small normally, but
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the investor would have to be somewhat bearish on the underlying stock in order to
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maximize his profit; that is, the stock would have to decline in price from the upper
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striking price to the middle striking price for the maximum profit to be realized. An
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analogous situation exists when the underlying stock is originally close to the lower
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striking price. The investor could establish the spread for a small debit in this case
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also, but he would now have to be somewhat bullish on the underlying stock in order
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to attempt to realize his maximum profit.
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Example: XYZ is at 70. One may be able to establish a low-debit butterfly spread
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with the 50's, 60's, and 70's if the following prices exist: |