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1. Table 1 contains information on call and put index options. Use this informa...

May 10, 2024

Solution

Constructing a Butterfly Spread with Calls: To construct a butterfly spread using call options, you buy one in-the-money call (lower exercise price), sell two at-the-money calls (middle exercise price), and buy one out-of-the-money call (higher exercise price)

Payoff for Butterfly Spread with Calls: The total cost of the butterfly spread is the sum of the premiums of the bought calls minus the premiums of the sold calls. The maximum profit occurs if the stock price at expiration is equal to the exercise price of the calls sold

Constructing a Butterfly Spread with Puts: Similarly, to construct a butterfly spread using put options, you buy one in-the-money put (higher exercise price), sell two at-the-money puts (middle exercise price), and buy one out-of-the-money put (lower exercise price)

Payoff for Butterfly Spread with Puts: The total cost of the butterfly spread is the sum of the premiums of the bought puts minus the premiums of the sold puts. The maximum profit occurs if the stock price at expiration is equal to the exercise price of the puts sold

Possible Outcomes: The butterfly spread is a limited risk, non-directional options strategy that is designed to have a high probability of earning a limited profit when the future volatility of the underlying asset is expected to be lower than the implied volatility of the options

Answer

To construct a butterfly spread using the given options, you would execute the following trades: Buy one K1 call, sell two K2 calls, buy one K3 call for the call butterfly spread. For the put butterfly spread, buy one K3 put, sell two K2 puts, buy one K1 put. The maximum profit for both spreads occurs if the stock price at expiration is at K2, and the maximum loss is limited to the net premium paid for the positions.

Key Concept

Butterfly Spread Strategy

Explanation

A butterfly spread involves buying and selling multiple options with different strike prices but with the same expiration date to limit risk and profit from low volatility around the middle strike price.