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Options Strategies
"Buy Butterfly" Option Investment Strategy
by InvestorGuide Staff (Write for us!)
(Click on the links within the article to get definition of that word)
Many savvy investors turn to options as a way of reducing risk - like hedging bets in their investment strategy.
The "buy butterfly" option investmentstrategy 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 currentmarket 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.
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