Short skip-strike butterfly spread with calls

  • The Options Institute at CBOE®

Goal

To profit from a stock price rise above the highest strike price with near-zero risk if the stock price falls below the lowest strike price while accepting the risk of a high-percentage loss if the stock price trades near the strike price of the long calls.

Explanation

Example of short skip-strike butterfly spread with calls

Sell 1 XYZ 95 call at 8.40 8.40
Buy 2 XYZ 100 calls at 4.80 (9.60)
Sell 1 XYZ 110 call at 0.95 0.95
Net debit = (0.25)

A short skip-strike butterfly spread with calls is a three-part strategy involving four calls. If there are four strike prices, A, B, C and D, with A being the lowest, a short skip-strike butterfly spread with calls is created by selling one call at strike A, buying two calls at strike B, skipping strike C and selling one call at strike D. All calls have the same expiration date, and the four strike prices are equidistant.

In the example above, one 95 Call is sold, two 100 Calls are purchased, the 105 strike is skipped, and one 110 Call is sold. In this example, the position is established for a small net debit, and both the potential profit and maximum risk are limited.

This is an advanced strategy because the maximum risk is high in percentage terms and because “costs” are high. Given three strike prices, there are multiple commissions in addition to three bid-ask spreads when opening the position and again when closing it. As a result, it is essential to open and close the position at “good prices.” It is also important to consider the per-contract commission rate since commissions will impact the return on investment.

Maximum profit

The maximum profit is equal to the difference between the strike price of two long calls and the highest strike price (short call) less the maximum risk. In the example above, the difference between the strike price of two long calls and the highest strike price is 10.00, and the maximum risk is 5.25 (see Maximum Risk below), not including commissions. The maximum profit, therefore is 4.75 (10.00 – 5.25).

If the position is established for a net debit as above, there are two loss scenarios. If the stock price is equal to or below the lowest strike price at expiration, then all calls expire worthless and the initial net debit paid for the position plus commissions is lost. If the stock price is equal to or above the highest strike price, then the maximum profit, as calculated in the previous paragraph, is realized.

If the position is established for a net credit, the maximum profit is realized if the stock price is equal to or above the highest strike price at expiration.

Maximum risk

The maximum risk is equal to the difference between the lowest strike price (short call) and the strike price of the two long calls plus the initial net debit or minus the initial net credit including commissions. This loss is realized if the stock price is at the strike price of the long calls at expiration.

In the example above, the difference between the lowest strike price and the strike price of the two long calls is 5.00, and the initial net debit is 0.25, not including commissions. The maximum risk, therefore, is 5.25 less commissions.

Breakeven stock price at expiration

If the position is established for a net debit as above, there is one breakeven point at expiration, and that is the stock price equal to the strike price of the long calls plus the maximum risk including commissions. In the example above, the strike price of the short calls is 100, and the maximum risk is 5.25, so the breakeven point at expiration is 105.25.

If the position is established for a net credit, there are two breakeven points at expiration. The lower breakeven point is the stock price equal to the strike price of the long calls minus the maximum profit. The upper breakeven point is the stock price equal to the strike price of the long calls plus the maximum risk.

Profit/Loss diagram and table: short skip-strike butterfly spread with calls

Sell 1 XYZ 95 call at 8.40 8.40
Buy 2 XYZ 100 calls at 4.80 each (9.60)
Sell 1 XYZ 110 call at 0.95 0.95
Net debit = (0.25)
Stock Price at Expiration Short 1 95 Call Profit/(Loss) at Expiration Long 2 100 Calls Profit/(Loss) at Expiration Short 1 110 Call Profit/(Loss) at Expiration Net Profit/(Loss) at Expiration
115 (11.60) +20.40 (4.05) +4.75
110 (6.60) +10.40 +0.95 +4.75
105 (1.60) +0.40 +0.95 (0.25)
100 +3.40 (9.60) +0.95 (5.25)
95 +8.40 (9.60) +0.95 (0.25)
90 +8.40 (9.60) +0.95 (0.25)

Appropriate market forecast

A short skip-strike butterfly spread with calls realizes its maximum profit if the stock price is at or above the highest strike on the expiration date. The forecast, therefore, must be bullish.

Strategy discussion

A short skip-strike butterfly spread with calls is the strategy of choice when the forecast is for a stock price to rise above the highest strike price of the spread. Unlike a long call, however, the initial cash outlay for a short skip-strike butterfly spread is minimal. Therefore, if the stock price drops sharply, instead of rising as forecast, the risk is minimal. However, there are three tradeoffs. First, the maximum risk of a short skip-strike butterfly spread is much higher than the initial cash outlay and possibly higher than the cost of a comparable call. Second, the profit potential is limited, whereas the profit potential of a long call is unlimited. Third, the commissions for a short skip-strike butterfly are much higher than for a long call.

Skip-strike butterfly spreads are sensitive to changes in the volatility in option prices, which is known as “implied volatility” (see Impact of Change in Volatility). The net price of a skip-strike butterfly spread falls when implied volatility rises and rises when implied volatility falls. Consequently some traders open short skip-strike butterfly spreads when they forecast that implied volatility will rise. Since implied volatility tends to rise in the period leading up to an earnings report, some traders will open a short skip-strike butterfly spread with calls two weeks or so before a report and hope for a stock price rise and a rise in implied volatility prior to the report. The position would then typically be closed immediately before the report. The potential profit is high in percentage terms and risk is limited if the stock price falls. However, if the stock price does not change and if implied volatility does not rise; the risk is very high in percentage terms.

Patience and trading discipline are required when trading short skip-strike butterfly spreads. Patience is required because this strategy profits from a rising stock price, and stock price action can be unsettling as it rises and falls around the highest strike price as expiration approaches. Trading discipline is required, because, as expiration approaches, “small” changes in stock price can have a high percentage impact on the price of a skip-strike butterfly spread. Traders must, therefore, be disciplined in taking partial profits if possible and also in taking “small” losses before the losses become “big.”

Impact of stock price change

“Delta” estimates how much a position will change in price as the stock price changes. Short calls have positive deltas, and short calls have negative deltas.

The net delta of a skip-strike butterfly spread remains close to zero until two weeks or so before expiration. As expiration approaches, if the stock price is below the lowest strike price in a short skip-strike butterfly spread with calls, then the net delta is slightly negative. If the stock price is above the highest strike price, then the net delta is slightly positive. Overall, a short skip-strike butterfly spread with calls profits from a rising stock price and is hurt by time decay if the stock price is near the strike price of the long calls.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to expiration remain constant. Short options, therefore, rise in price and make money when volatility rises, and short options rise in price and lose money when volatility rises. When volatility falls, the opposite happens; short options lose money and short options make money. “Vega” is a measure of how much changing volatility affects the net price of a position.

Short skip-strike butterfly spreads with calls have a positive vega. This means that the price of a skip-strike butterfly spread falls when volatility rises (and the short spread makes money). When volatility falls, the price of a skip-strike butterfly spread rises (and the short spread loses money). Short skip-strike butterfly spreads, therefore, should be purchased when volatility is “low” and forecast to rise.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion. “Theta” is a measure of how much time erosion affects the net price of a position. Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion.

A short skip-strike butterfly spread with calls has a net negative theta if the stock price is near the strike price of the long calls. If the stock price moves away from this strike price, however, the theta becomes positive as expiration approaches.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation. Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long calls in a short skip-strike butterfly spread have no risk of early assignment, the short calls do have such risk. Early assignment of stock options is generally related to dividends. Short calls that are assigned early are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less than the dividend have a high likelihood of being assigned.

If one short call is assigned (most likely the lowest strike call), then 100 shares of stock are sold short and the long calls and the other short call remain open. If a short stock position is not wanted, it can be closed in one of two ways. First, 100 shares can be purchased in the marketplace. Second, the short 100-share position can be closed by exercising the one of the long calls. Remember, however, that exercising a long call will forfeit the time value of that call. Therefore, it is generally preferable to buy shares to close the short stock position and then sell the long call. This two-part action recovers the time value of the long call. One caveat is commissions. Buying shares to cover the short stock position and then selling the long call is only advantageous if the commissions are less than the time value of the long call.

If both of the short calls are assigned, then 200 shares of stock are sold short and the long calls remain open. Again, if a short stock position is not wanted, it can be closed in one of two ways. Either 200 shares can be purchased in the market place, or both long calls can be exercised. However, as discussed above, since exercising a long call forfeits the time value, it is generally preferable to buy shares to close the short stock position and then sell the long calls. The caveat, as mentioned above, is commissions. Buying shares to cover the short stock position and then selling the long calls is only advantageous if the commissions are less than the time value of the long calls.

Note, however, that whichever method is used, buying stock and selling the long call or exercising the long call, the date of the stock purchase will be one day later than the date of the short sale. This difference will result in additional fees, including interest charges and commissions. Assignment of a short option might also trigger a margin call if there is not sufficient account equity to support the stock position created.

Potential position created at expiration

The position at expiration of a short skip-strike butterfly spread with calls depends on the relationship of the stock price to the strike prices of the spread.

If the stock price is below the lowest strike price, then all calls expire worthless, and no position is created.

If the stock price is above the lowest strike (short call) and at or below the strike price of the two short calls, then the lowest strike short call is assigned. The result is that 100 shares of stock are sold and a stock position of short 100 shares is created.

If the stock price is above the strike of the two long calls and at or below the highest strike (short call), then the lowest-strike short call is assigned and the two long calls are exercised. The result is that 100 shares are sold and 200 shares are purchased. The net result is a long position of 100 shares.

If the stock price is above the highest strike, then both short calls (lowest and highest strikes) are assigned and the two long calls (strike in between) are exercised. The result is that 200 shares are purchased and 200 shares are sold. The net result is no position, although several stock buy and sell commissions have been incurred.

Other considerations

A short skip-strike butterfly spread with calls can also be described as the combination of a “narrow” bear call spread and a “wide” bull call spread. In the example above, the narrow bear call spread is comprised of the short 95 Call and one of the long 100 Calls. The wide bull call spread is comprised of the other long 100 Call and the short 110 Call.

A frequent source of confusion regarding skip-strike butterfly spreads is the margin requirement. While the margin requirement for most spread strategies is equal to the maximum risk of the strategy, this is not the case for skip-strike butterfly spreads. In this strategy, the bear call spread and the bull call spread are margined separately. Consequently, the total margin requirement for a skip-strike butterfly can be greater than the maximum risk of the strategy.

In the example above, the 95-100 bear call spread is sold for a net credit of 3.60 (8.40 – 4.80) not including commissions. The maximum risk of this spread and, therefore, the margin requirement is 1.40. The 100-110 bull call spread is purchased for 3.85 (4.80 – 0.95).

First, for purposes of margin, the margin requirement for the bear call spread is the maximum risk of the spread, or $615 in this example. In the example above, $360 of cash is set aside from account equity. Second, the bull call spread must be paid for. Therefore, the total margin requirement for the skip-strike butterfly spread in the example above is $525 ($1.40 + $385), not including commissions. Note that the cash received for the bear call spread is held in reserve as part of its margin requirement; the cash received for the bear call spread is not applied to the cash paid for the bull call spread.

Skip-strike butterfly spreads are also known as “broken-wing butterfly spreads.” The term “butterfly” is thought to have originated from the profit-loss diagram of a long butterfly spread, because the peak in the middle of the diagram looks vaguely like the body of a butterfly, and the horizontal lines stretching out to either side look vaguely like the wings of a butterfly. The term “broken-wing” is thought to be a comparison of the profit-loss diagrams of the standard long butterfly and the long skip-strike butterfly. Whereas the “wings” of a standard butterfly spread are even, the wings of a skip-strike butterfly are uneven or “broken.”