Question

If ABC stock is selling for 50 and there are liquid markets in nearby calls at two point intervals. How would you construct a call butterfly and of what use could it be to you?

Answer 1

Call butterfly is option strategy that involves selling two call option at same strike price and simultaneously purchasing one call option at higher strike price and one call option at lower strike price. This strategy will be beneficial when market trades in narrow range

In case stock is selling at 50$ then butterfly strategy can be formed as under
Sell 2 call option @ strike price of 50
Buy 1 call option @ strike price of 40
Buy 1 call option @ strike price of 60

Table showing payoff

Price as on Expiry	Profit/loss on short call	Profit/loss on long call @60	Profit/loss on long call @40	Total Profit
40	0	0	0	0
41	0	0	1	1
42	0	0	2	2
43	0	0	3	3
44	0	0	4	4
45	0	0	5	5
46	0	0	6	6
47	0	0	7	7
48	0	0	8	8
49	0	0	9	9
50	0	0	10	10
51	-2	0	11	9
52	-4	0	12	8
53	-6	0	13	7
54	-8	0	14	6
55	-10	0	15	5
56	-12	0	16	4
57	-14	0	17	3
58	-16	0	18	2
59	-18	0	19	1
60	-20	0	20	0