Question

Butterfly Spread – Graphical a) Draw the net profit diagrams for each of the three call positions and the entire butterfly trade using the following attributes – Call 1: Strike = $50, Premium = $1 – Call 2: Strike = $52, Premium = $1.75 – Call 3: Strike = $54, Premium = $3 What does it cost to put on this trade? b) Suppose you reverse the positions and write Call 1 and Call 3, and buy two Call 2s. Draw the same net profit diagram. Why would you take on such a position?

What does it cost to put on this trade? (If you get paid, that’s a negative cost).

Answer 1

The cost to put on the original butterfly spread is $0.50 per set of options. Reversing positions results in a credit of $0.50 per set of options, suitable for a market with low volatility expectations.

Step-by-step explanation:

To analyze the butterfly spread using the given options, we first need to determine the net profit or loss for each call position at expiration based on the stock's final price.

• Call 1: Long call with a strike price of $50 and a premium of $1.
• Call 2: Short call with a strike price of $52 and a premium of $1.75 (times two for two options).
• Call 3: Long call with a strike price of $54 and a premium of $3.

The initial cost to put on this butterfly trade is the sum of premiums paid minus premiums received: ($1 + $3) - (2 × $1.75) = $4 - $3.50 = $0.50 per set of options.

For part b), if you reverse the positions (writing Call 1 and Call 3, and buying two Call 2s), the net profit diagram would be inverted, resembling a short butterfly spread. This reversal results in receiving premiums from written calls while paying for the bought calls, and the cost to put on this trade, or income received, would be: (2 × $1.75) - ($1 + $3) = $3.50 - $4 = -$0.50, which means you would receive $0.50 per set of options.

Taking on such a reversed position might be due to a market outlook that expects low volatility, where the stock price is not anticipated to move much from the short position's strike by expiration.