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Options Strategies
"Sell Butterfly" Option Investment Strategy
by InvestorGuide Staff (Write for us!)
(Click on the links within the article to get definition of that word)
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 strikeprice
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 premiumpaid 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 investorwants 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 bullishmarket. 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).
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