Bulls and Butterflies

binary options
Bulls and Butterflies

A call spread or bull vertical spread is created by buying a call and simultaneously selling another call with a higher strike price.

The spread is profitable if the underlying asset increases in price, but this upside is limited by virtue of the short call.

The benefit, however, is that selling the call reduces the cost of buying the other one.

Similarly, a put spread or bear vertical spread involves buying a put and selling a second put with a lower strike.

If you buy and sell options with different expirations it is known as a calendar spread or time spread.

A butterfly consists of options at three strikes, equally spaced apart, where all options are of the same type (either all calls or all puts) and have the same expiration.

In a long butterfly, the middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two, buy one).

If this ratio does not hold, it is not a butterfly.

The outside strikes are commonly referred to as the wings of the butterfly, and the inside strike as the body.

The value of a butterfly can never fall below zero.

An example of a butterfly would be to go long a 60 call, short two 65 calls, and long a 70 call.

The identical spread could also be made with long the 60 put, short two 65 puts, and long a 70 put.

Being long a butterfly profits from a quiet market.

Similar to a butterfly are the condor, iron butterfly, and iron condor.

Combining options positions with the underlying can also produce synthetic options.

This has to do with what is known as put-call parity where:

Call Price – Put Price = Underlying Price – Strike Price.

Rearranging this equation we can create a synthetic long call for a given strike price by buying a put and also buying the underlying.

A synthetic put is likewise a long call combined with going short the underlying.

Combining spreads with a trade in the underlying can also create novel positions such as the collar, fence, or risk reversal, all names for the same strategy:

Selling an upside call, buying a downside put, and buying the underlying!