Option trading explained: The butterfly strategy
For example the left at 80$ and the right at 120$ or the left at 70$ and the right at 130$. Our choice depends on the volatility of the underlying and the time to maturity. The choices will not be discussed in detail here. Let’s just pick 80$ and 120$ for our example. Add a 100$ long call to the 80$ short call we started out with as the left wing of the butterfly. This flattens the pay off diagram out at 100$. To make it upward sloping we add one more. The butterfly is starting to take shape but we’re not yet there. What more should be added? Think about it for a second before you read further.
Ill left 2/3rd of butterfly
Well, the slope of the 80$ short call and 100$ to the right of the intended center needs to be flattened out. We’ve already decided on 120$ to be were this flattening of the option trading strategy should take place. The angle of our current option combination above 100$ looks like a long call. So we could cancel it out by adding a short call. So we simply add a short call with a 120$ strike the get the 3rd kink of the pay off diagram and the option trading strategy is complete.
I’ve mentioned in other pages on this site that you can create any given pay off profile in different ways. To improve your intuitive thinking it’s a good exercise to try to come up with an alternative way of making a butterfly. Let’s start by looking at the butterfly from the right instead of the left part. What does the right half look like? Right, a short put. So let’s try to make a butterfly option trading strategy by starting with a short put with a strike of 120$. What do we add to make the downward sloping part turn upwards at 100$? Two long put options with strike 100$ of course. And going further to the left we add another short put option with strike price 80$. Voila! Another way to make a Butterfly.