The short butterfly is a neutral strategy like the long butterfly but bullish on volatility. It is a limited profit, limited risk options trading strategy. There are 3 striking prices involved in a short butterfly spread and it can be constructed using calls or puts.
Sell 1 ITM Call, Buy 2 ATM Calls, Sell 1 OTM Call
Short Call Butterfly
Using calls, the short butterfly can be constructed by writing one lower striking in-the-money call, buying two at-the-money calls and writing another higher striking out-of-the-money call, giving the trader a net credit to enter the position.
Limited Profit
Maximum profit for the short butterfly is obtained when the underlying stock price rally pass the higher strike price or drops below the lower strike price at expiration.
If the stock ends up at the lower striking price, all the options expire worthless and the short butterfly trader keeps the initial credit taken when entering the position.
However, if the stock price at expiry is equal to the higher strike price, the higher striking call expires worthless while the "profits" of the two long calls owned is canceled out by the "loss" incurred from shorting the lower striking call. Hence, the maximum profit is still only the initial credit taken.
Net Premium Received - Commissions Paid
Profit achieved when: Price of Underlying <= Strike Price of Lower Strike Short Call OR Price of Underlying >= Strike Price of Higher Strike Short Call
Limited Risk
Maximum loss for the short butterfly is incurred when the stock price of the underlying stock remains unchange at expiration. At this price, only the lower striking call which was shorted expires in-the-money. The trader will have to buy back the call at its intrinsic value.
Strike Price of Long Call - Strike Price of Lower Strike Short Call - Net Premium Received + Commissions Paid
Loss occurs when: Price of Underlying = Strike Price of Long Calls
Breakeven points
Strike Price of Highest Strike Short Call - Net Premium Received
Strike Price of Lowest Strike Short Call + Net Premium Received
Example
Suppose XYZ stock is trading at $40 in June. An options trader executes a short call butterfly strategy by writing a JUL 30 call for $1100, buying two JUL 40 calls for $400 each and writing another JUL 50 call for $100. The net credit taken to enter the position is $400, which is also his maximum possible profit.
On expiration in July, XYZ stock has dropped to $30. All the options expire worthless and the short butterfly trader gets to keep the entire initial credit taken of $400 as profit. This is also the maximum profit attainable and is also obtained even if the stock had instead rallied to $50 or beyond.
On the downside, should the stock price remains at $40 at expiration, maximum loss will be incurred. At this price, all except the lower striking call expires worthless. The lower striking call sold short would have a value of $1000 and needs to be bought back. Subtracting the initial credit of $400 taken, the net loss (maximum) is equal to $600.
Commissions
These examples exclude commissions and fees. Include all transaction costs when evaluating the profit or loss of a position.
Similar strategies
Long Butterfly
The converse strategy to the short butterfly is the long butterfly. Long butterfly spreads are used when one perceives the volatility of the price of the underlying stock to be low.
Short Put Butterfly
The short butterfly can also be created using puts instead of calls and is known as a short put butterfly.
Wingspreads
The short butterfly spread belongs to a family of spreads called wingspreads whose members are named after a myriad of flying creatures.