How to use this tool
How to use this tool
"Sell Butterfly" Option Investment Strategy
by InvestorGuide Staff (Write for us!)
(Click on the links within the article to get definition of that word)
(Click on the links within the article to get definition of that word)
A stock option may seem like a fairly simple investment tool
because basically, it is a contract giving the holder
the right (but not the obligation) to buy or sell 100 shares of stock at a fixed price before a given expiration date.
However, option investment strategies tend to be complicated because they are often used as hedges against
other investments. Some option strategies even use different kinds of options to hedge against other options.
In the world of stock options, there are two basic choices - "calls" or "puts." A call option assumes that the underlying value of the stock will increase before the expiration date. The strike price represents the predicted value of the stock by the time the option expires.
The owner of a call option does not actually buy the underlying stock - but he/she has the right to, should the value exceed the break even point on or before the expiration date. If the value of the stock rises above the strike price by the expiration date, then the owner of the call option has the right to buy the stock at the market value during the time of purchase. If the stock price does not reach the strike price before the option expires, then the investment is a total loss (and that loss amounts to the premium paid for the option plus any commissions). A put option assumes that the value of the stock will decrease to, or below the strike price by the time of expiration.
No investor wants to see a total loss, which is why the "sell butterfly" option investment strategy is often used. Investors using this strategy will sell a call option with a low strike price and receive a hefty premium since lower strike prices carry less risk and are therefore more likely to be profitable - less risk means increased premium prices.
Then, the investor will purchase two call options with a medium range strike price, while also selling another call option with a high strike price (but receiving a lower premium than when selling the lower strike call option). The same strategy can be used with put options but remember that they assume the price of the underlying stock will decrease in value by the expiration date.
Investors opt for the "sell butterfly" strategy when they believe that stock prices will fluctuate greatly in the foreseeable future. But while the "sell butterfly" call option assumes that prices will be volatile, there is still the expectation for prices to trend upward in a bullish market. This option investment technique assumes that prices will be volatile - but will trend upwards. The "sell butterfly" investment strategy can also be used with put options when investors believe that prices will be volatile but trend downward - or be bearish.
The maximum profit for those using the sell butterfly option investment strategy will be limited to the initial credit when setting up the butterfly spread. Losses are also limited in this investment style and will not exceed the difference between the lower strike and the combination of the two middle strikes minus the initial credit (the maximum profit mentioned earlier).
In the world of stock options, there are two basic choices - "calls" or "puts." A call option assumes that the underlying value of the stock will increase before the expiration date. The strike price represents the predicted value of the stock by the time the option expires.
The owner of a call option does not actually buy the underlying stock - but he/she has the right to, should the value exceed the break even point on or before the expiration date. If the value of the stock rises above the strike price by the expiration date, then the owner of the call option has the right to buy the stock at the market value during the time of purchase. If the stock price does not reach the strike price before the option expires, then the investment is a total loss (and that loss amounts to the premium paid for the option plus any commissions). A put option assumes that the value of the stock will decrease to, or below the strike price by the time of expiration.
No investor wants to see a total loss, which is why the "sell butterfly" option investment strategy is often used. Investors using this strategy will sell a call option with a low strike price and receive a hefty premium since lower strike prices carry less risk and are therefore more likely to be profitable - less risk means increased premium prices.
Then, the investor will purchase two call options with a medium range strike price, while also selling another call option with a high strike price (but receiving a lower premium than when selling the lower strike call option). The same strategy can be used with put options but remember that they assume the price of the underlying stock will decrease in value by the expiration date.
Investors opt for the "sell butterfly" strategy when they believe that stock prices will fluctuate greatly in the foreseeable future. But while the "sell butterfly" call option assumes that prices will be volatile, there is still the expectation for prices to trend upward in a bullish market. This option investment technique assumes that prices will be volatile - but will trend upwards. The "sell butterfly" investment strategy can also be used with put options when investors believe that prices will be volatile but trend downward - or be bearish.
The maximum profit for those using the sell butterfly option investment strategy will be limited to the initial credit when setting up the butterfly spread. Losses are also limited in this investment style and will not exceed the difference between the lower strike and the combination of the two middle strikes minus the initial credit (the maximum profit mentioned earlier).
Email this Article
Print this Article
Cite this Article
Other Suggested Articles
"Bull Spread" Stock Option Investment Strategy >
"Bear Spread" Stock Option Investment Strategy >
"Sell Covered Call" Option Investment Strategy >
"Buy Straddle" Option Investment Strategy >
"Buy Butterfly" Option Investment Strategy >
"Buy Call" Option Investment Strategy >
"Sell Naked Put" Stock Option Investment Strategy >
"Buy Condor" Stock Option Investment Strategy >
"Buy Put" Stock Option Investment Strategy >
Copyright© 2009 by InvestorGuide.com. All rights reserved.
Unauthorized duplication, in whole or in part, is strictly prohibited.
Click here to license this content.
Unauthorized duplication, in whole or in part, is strictly prohibited.
Click here to license this content.
