Short Skip-Strike Butterfly Spread With Calls

Options strategies may be confusing for beginners. However, after you gain some experience in the market, you will start to see how different strategies work for different market conditions. Finding the perfect strategy for any given market may be the next challenge you face. 

Fortunately, this is no longer a major hassle, thanks to the advanced tools available to traders today — like Options B.R.O. from Samco Securities. This advanced tool builds, researches and optimises options strategies for you within seconds. You can then choose the optimal strategy for any market condition and implement it efficiently.

Another major advantage of options trading strategies is that you can tailor an existing setup to align with a potential skew in the price direction. The short butterfly spread using calls is an excellent example of this phenomenon in action. It is essentially a multi-legged options trading strategy that can be useful if you have a bullish outlook.

Let us take a closer look at what the short butterfly call option spread entails and how it can be adjusted just by skipping one strike price.

What is a Short Butterfly Spread With Calls?

The short butterfly spread using calls uses three different strike prices that increase in an equidistant manner. The aim of this strategy is to profit from the spot price moving below the lowest strike price or above the highest strike price in the trade. To set up this type of call butterfly strategy, you need to execute the following trades:

• Trade 1: Sell one in-the-money (ITM) call option that has a lower strike price
• Trade 2: Buy two at-the-money (ATM) call options that each have the same middle strike price
• Trade 3: Sell one out-of-the-money (OTM) call option that has a higher strike price

The difference between the lower and middle strike prices in this butterfly spread strategy is the same as the difference between the middle and higher strike prices. All the call options have the same underlying asset and the same expiry. Typically, this position results in a net credit because you obtain a high premium for the ITM short call and a lower premium for the OTM short call. You can set up this butterfly options strategy so that the premium you pay for the two long calls is less than the premiums received for the short calls.

That said, what if you expect the share price to be more bullish than bearish? In other words, what if you have a bullish skew in your market outlook? In that case, you can opt for the skip-strike short butterfly spread options strategy using calls. Let us discuss what this entails.

What is a Skip-Strike Short Butterfly Spread With Calls?

The skip-strike short butterfly spread using calls is a variant of the original short butterfly spread discussed above. It is set up in a similar manner, with four trades spread across three strike prices. However, the main difference is that you skip one strike price and opt for the next higher strike when setting up the third trade.

Here’s an example to help you understand this better. Say there are four equidistant strike prices. Let’s call them A, B, C and D, where A is the lowest price. If you want to execute a skip-strike short butterfly options strategy, you must implement the following trades:

• Trade 1: Sell one ITM call at strike price A
• Trade 2: Buy two ATM calls at strike price B
• Trade 3: Skip strike price C and sell one OTM call at strike price D instead

Since you are essentially selling the call at a higher strike, making it further out of the money, the premium obtained will be lesser here when compared with a traditional short butterfly spread with calls. This means the positions may be set up for a small net debit instead of the net credit available in the standard version. If this is the case, why skip a strike price and set up a trade as explained above? What are the benefits of choosing a higher strike price? Let’s find out.

Why Skip a Strike Price?

You can modify the typical short butterfly spread using calls and skip a strike price if you expect that the price of the underlying asset may close above the highest strike price in the setup. With this kind of bullish outlook, beginners to the options market may attempt to take a long call position and call it a day. However, a long call may be costlier to set up.

In stark contrast, the net debit for the skip-strike short call butterfly spread options strategy is minimal, making it a cost-effective way to take advantage of a potentially steep bullish price movement in the underlying asset. Another advantage of the skip-strike short butterfly spread using calls is that it minimises the risk if the price falls instead of rising.

So, the fundamental idea is to use the skip-strike method if you are fairly certain that the stock price will rise steeply at expiry — well beyond the highest striker price in the spread. 

Important Price Levels in the Skip-Strike Short Call Butterfly Spread 

Before setting up the skip-strike short butterfly call options strategy, you need to be aware of the various key price levels for this trade. This includes the maximum potential profit, the maximum possible loss and the break-even price points.

Let us decode each of these price levels in detail, so you can better understand how to set up the trade to maximise profits and minimise losses.

• Maximum Profit

This trade is the most profitable if the underlying asset’s price rises as expected, beyond the higher strike price in the spread. You can compute the maximum profit from this trade using the formula shown below:

Maximum Gain = Higher Strike Price — Skipped Strike Price — Net Premium Paid

This means that the maximum profit from the trade is limited. No matter how high the spot price rises above strike price D, the profit is capped at the above-mentioned level.

• Maximum Loss

The maximum loss represents the highest risk associated with a trade. In a skip-strike short butterfly spread using calls, the maximum loss can be computed using this formula:

Maximum Loss = Middle Strike Price — Lower Strike Price + Net Premium Paid

Like the maximum possible profit, the maximum potential loss is also limited. However, you need to be sure that you can absorb this loss if the market does not move as expected. Otherwise, you may have to find a different strategy that aligns with your risk-return preferences.

• Break-Even Prices

The break-even point is the price level at which there are no profits or losses. In other words, you neither gain nor lose. The skip-strike butterfly spread using calls has different break-even points, depending on whether you set up the trade for a net debit or a net credit.

If the spread is set up at a net credit, the break-even price can be any one of the following two prices:

Break-Even Price = Lower Strike Price + Net Premium Received (OR) Skipped Strike Price — Net Premium Received

However, if you set up this butterfly spread at a net credit, you can use the following formula to find the break-even price: 

Break-Even Price = Skipped Strike Price + Net Premium Paid

Knowing the break-even prices can help you understand the threshold point below or above which the stock price must not move at expiry. You can then use technical analysis to find the support or resistance levels as needed, compare them with the break-even prices and decide whether the skip-strike butterfly call options strategy is a realistic alternative for the market movement that you expect.

The Skip-Strike Short Butterfly Spread With Calls: An Example

Having seen the different crucial price points of the skip-strike short butterfly spread using calls, you may already have a fair idea of what to expect when you choose this multi-legged trade. However, knowing the theory alone is not enough. So, let us discuss a practical example of how this complex strategy works.

Say a stock is currently trading at Rs. 623 and you expect it to rise steeply to Rs. 650 or higher over the next month. So, you set up a skip-strike short butterfly spread strategy as outlined below: 

• Trade 1: Sell 1 call option with a strike price of Rs. 620 and a lot size of 10 shares and receive Rs. 23 per share (or Rs. 230 in total)
• Trade 2: Buy 2 call options, each with a strike price of Rs. 630 and a lot size of 10 shares by paying Rs. 18 per share (or Rs. 360 in total)
• Trade 3: Skip the strike price of Rs. 640 sell 1 call option with a strike price of Rs. 650 and a lot size of 10 shares and receive Rs. 9.60 per share (or Rs. 96 in total)

The net debit edit for this trade is Rs. 34 (i.e. Rs. 230 — Rs. 360 + Rs. 96). Let us see how different outcomes of this trade may play out. 

• Scenario 1: Stock Price at Expiry is at or Below Rs. 620 

In this case, all options expire worthless because the stock is below the lowest strike (Rs. 620). So, your loss is limited to the net debit paid upfront, i.e. Rs. 34.

• Scenario 2: Stock price at Expiry = Rs. 630 

• The Rs. 620 call is in the money (ITM) and leads to a loss of Rs. 10 per share (difference between Rs. 630 and Rs. 620) or Rs. 100 in total.
• The Rs. 630 calls expire at the money (ATM), worth Rs. 0.
• The Rs. 650 call expires worthless.
• Total Loss = Rs. 100 + Net Debit of Rs. 34 = Rs. 134.

• Scenario 3: Stock Price at Expiry = Rs. 640 

• The Rs. 620 call is in the money (ITM) and leads to a loss of Rs. 20 per share (difference between Rs. 640 and Rs. 620) or Rs. 200 in total.
• The Rs. 630 calls are in the money and lead to a profit of Rs. 10 each (difference between Rs. 640 and Rs. 630) or Rs. 200 in total.
• The Rs. 650 call expires worthless.
• Total Loss = Rs. 200 (loss from short call at lower strike) — Rs. 200 (gain from long calls) + Net Debit of Rs. 34 = Rs. 34.

• Scenario 4: Stock price at Expiry = Rs. 650 

• The Rs. 620 call is in the money (ITM) and leads to a loss of Rs. 30 per share (difference between Rs. 650 and Rs. 620) or Rs. 300 in total.
• The Rs. 630 calls are in the money and lead to a profit of Rs. 20 each (difference between Rs. 650 and Rs. 630) or Rs. 400 in total.
• The Rs. 650 call expires at the money, worth Rs. 0.
• Total Profit = Rs. 400 (gain from long calls) — Rs. 300 (loss from short call at lower strike) — Net Debit of Rs. 34 = Rs. 66.

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Multi-legged strategies like this require careful consideration of the various possible outcomes and profit and loss analysis. It is impossible to manually check these calculations and execute the trade instantly in a dynamic market. However, Options B.R.O. from Samco Securities makes the impossible possible.

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