A Note On Investment Strategies Involving Options

INVESTMENT STRATEGIES INVOLVING OPTIONS Contd..

Butterfly Spread

A butterfly spread is an option strategy involving four options of the same type, having the same expiration date but three different exercise prices. A butterfly spread can be created by buying an option each at two extreme strike prices (X1 and X3) and selling two options with a strike price (X2), which is halfway between X1 and X3. The strike price should be so chosen that X1 < X2 < X3. Generally, X2 should be close to the prevalent market price.

Example:

An investor buys two March call options on shares of Reliance, one at a premium of Rs. 25 per share with a strike price of Rs.200 (X1) and the other at a premium of Rs. 15 per share with a strike price of Rs. 300 (X3). The investor also sells two March call options at a premium of Rs. 17 per share with a strike price of Rs. 250 (X2). The payoff table (Refer Table 8) of a butterfly spread using calls will be:

Table 8: Payoff using Butterfly Spread

S	X1	X2	C	Payoff	Net Profit
180	200	250	300	6	0	-6
200	200	250	300	6	0	-6
220	200	250	300	6	20	14
240	200	250	300	6	40	34
250	200	250	300	6	50	44
260	200	250	300	6	40	34
280	200	250	300	6	20	14
300	200	250	300	6	0	-6
320	200	250	300	6	0	-6

In the case of a butterfly spread using calls, the payoff will be:

Payoff when,	From Call bought at X1	From Two Calls sold at X2	From Call bought at X3	Total Payoff
S � X1	0	0	0	0
X1 � S � X2	S � X1	0	0	S � X1
X2 � S � X3	S � X1	- 2 * (S � X2)	0	X3 � S
S > X3	S � X1	- 2 * (S � X2)	S � X3	0

* These payoffs will hold true only when X2 is halfway between X1 and X3

Investors adopt the butterfly spread strategy when they are certain that the prices will fluctuate significantly and want to limit their downside risk. This strategy limits both the upside potential as well as the downside risk. The upside potential is limited to the difference between (the middle exercise price and the lower exercise price) less the net option premium while the downside risk is limited to the amount of net option premium paid to create the spread.

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TABLE 9: PAYOFF USING CONDOR SPREAD

TABLE 10: PAYOFF FROM LONG STRADDLE

TABLE 11: PAYOFF FROM LONG STRANGLE

TABLE 12: PAYOFF USING STRIPS

TABLE 13: PAYOFF USING STRAP

CONCLUSION

EXHIBIT I

ADDITIONAL READING & REFERENCES