Options are contracts between buyers and sellers granting the buyer the right, but not the obligation, to buy or sell 100 shares of the underlying stock. The strike price of an option represents the predicted value that the underlying stock will reach by the time of expiration. Investors must pay a premium when purchasing options – which must be paid regardless of if the underlying stock is ever actually bought or sold. Call options are purchased by investors who believe that the underlying stock price will increase to the strike price, or better still, above the strike price before the expiration date, while put options are acquired by those investors who believe the price will drop by the expiration date.
Many savvy investors turn to options as a way of reducing risk – like hedging bets in their investment strategy. The “buy butterfly” option investment strategy is a fairly complicated way of hedging against potential loss. While using the “buy butterfly” strategy, an investor will buy a call option with a low strike price, which will have a higher premium, because there is less risk that the option will not reach the strike price before the expiration date. Then, the investor will sell off two call options with medium-range strike prices. Finally, the investor will then buy one final call option with a high strike price, which will have a lower premium because there is less chance of the stock rising to or above the strike price before expiration. But, having the ability to buy the option at current market price (when the option was purchased) should the value of the stock rise by the expiration date – offers the potential for big profits.
The “buy butterfly” strategy is used when an investor believes that there will be fluctuation in the stock price – but only within a limited range. In other words, the investor is betting that the low strike price and the high strike price are the limits of that range. The two options that were sold at medium strike price help mitigate the potential loss by providing the investor with the premiums for selling the options.
Profit is limited for investors using the “buy butterfly” strategy because the maximum profit is reached when the stock price settles at the high strike price. Losses are also limited in this strategy. The maximum loss is realized when the final stock price settles below the low strike price or above the high strike amount. The total loss is limited to the amount paid to create the “butterfly” spread (the total cost of the premiums paid for purchasing the high and low strike price options, minus the premiums received when selling the medium strike price options, plus all the commissions paid for all the transactions).
The “buy butterfly” option investment strategy is somewhat complicated and is not recommended for novice investors.Although the total loss is limited, it is difficult for beginning investors to determine an acceptable range for stock price fluctuation.