Description
A Long Butterfly
is a
Short Straddle
with a conservative
twist! By purchasing
two out-of-the-money
options (one Put
and one Call) the
investor's maximum
risk exposure becomes
definable.
When to use
As was the case
with the Short Straddle,
the investor should
select this position
only if XYZ is expected
to trade within
plus-or-minus 5%
of $60 over the
next 90 days. By
buying the two options,
the straddle's risk
has been capped,
but the range of
profitability has
been reduced.
Risk/Reward
Characteristics
Unlike the Short
Straddle, this strategy
has limited risk.
It can be viewed
as being short one
60-65 Call Vertical
and short one 55-60
Put Vertical. It's
maximum potential
profit point is
at the strike price
($60) at expiration,
and it is equal
to the spread's
initial credit.
Most of profit develops
in the last month
because of rapid
time decay. Maximum
loss in either direction
is equal to strike
price differential
of one vertical
spread (5) minus
initial credit.
Break-even
Point: Upside:
Strike price of
straddle + net premium
received. Downside:
Strike price of
straddle - net premium
received.
Time Decay:
Positive. If XYZ
is near the strike
price (60), profits
from decay accelerate
most rapidly in
last few weeks before
expiration.
Volatility:
Because an increase
in volatility has
a larger impact
on the two options
making up the straddle
than the two OTM
options, an increase
in volatility is
a negative for the
spread. The impact
will depend to a
large part on both
the amount of time
left until expiration
and the price of
XYZ relative to
the strike price.
Because an increase
in volatility can
have a negative
impact, it is important
that the implied
volatilities of
XYZ's option be
near historic highs
before an investor
consider this spread.
Assignment
Risk: This spread
contains two written
options. The investor
must watch XYZ for
possible assignment
if XYZ is either
significantly above
or below the strike
price as expiration
approaches. By monitoring
the time premium
of the in-the-money
option, the investor
can determine the
likelihood of assignment.
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