Advanced Options: Exploiting Volatility with the Short Call Butterfly

              

In Wednesday's edition of Advanced Options, we analyzed the short call butterfly spread, which allows investors to profit from significant price swings in either direction. In today's column, we're going to make this unique option play even more tangible by dissecting a hypothetical short call butterfly on satellite sultan DISH Network Corp. (DISH: sentiment, chart, options).

A Second Look at the Short Butterfly

Before we delve into our theoretical trade, let's quickly review what we know about this three-tiered strategy. The option play should be employed by investors anticipating a sharp move higher or lower from the underlying stock, with many traders implementing the strategy ahead of potential momentum-inducing events like earnings or monthly sales releases.

To initiate the short call butterfly, the investor would buy two at-the-money calls (which represent the "body" of the butterfly), while simultaneously selling one in-the-money and one out-of-the-money call (representing the "wings" of the butterfly). All of the options should have the same expiration month, with the trade resulting in a net credit at initiation.

The primary goal is for the underlying security to violate one of two breakeven levels before expiration: the lowest strike plus the net credit, or the highest strike less the net credit. Both the risk and reward are limited with the short call butterfly, with the maximum potential gain capped at the initial credit, and the maximum potential loss tallied by subtracting the lower-strike call from the long call strike, minus the net credit.

(Don't forget to include any margin requirements, brokerage fees or commission costs in your calculations.)

Searching for a Short Butterfly

So, why did we select DISH for our conceptual short call butterfly? Most notably, because the television titan has a date in the earnings confessional on its near-term agenda. More specifically, the company is slated to report its third-quarter figures before the opening bell on Monday, Nov. 9, according to Thomson Reuters.

What's more, from an historical perspective, DISH has a tendency to miss or exceed the Street's per-share earnings predictions by a rather wide margin. In fact, the company has reported earnings in line with the consensus estimate only once in the last four quarters, with the actual per-share figures off by an average margin of 26 cents.

Considering the short call butterfly profits on a significant price swing, we're hoping to exploit another off-the-charts earnings surprise from DISH.

Initiating the Play

Since the firm is expected to take the earnings reins next week, we're going to hone in on November-dated calls for our short butterfly. With the shares of DISH currently flirting with the $18 level, the stock's November 18 strike seems a likely candidate for our two purchased calls. These front-month options were last asked at $1.20, making the combined cost of our two long calls $2.40.

Meanwhile, we're going to establish the "wings" of our butterfly by simultaneously selling the November 15 call, which was last bid at $3.40, and the November 21 call, which was last bid at $0.10. Subtracting the $2.40 paid for the two at-the-money calls from the combined $3.50 received for the written calls, our short call butterfly is initiated for a net credit of $1.10.

However, in order to hang on to that net credit – which represents the most we stand to gain on the play – we need the shares of DISH to breach one of two breakeven rails by options expiration on Nov. 20: the $16.10 level (15 + $1.10), or the $19.90 level (21 - $1.10).

Fast-forwarding to DISH's upcoming turn in the earnings spotlight, let's assume the company's third-quarter figures are in line with analysts' expectations. As a result, investors remain apathetic, and the shares of DISH remain flat at the $18 level.

In this worst-case scenario, our two purchased 18-strike calls and the sold 21-strike call would expire worthless. In addition, our written 15-strike call would be three points in the money, costing us $3 to repurchase. Subtracting our initial credit of $1.10, our short call butterfly would result in a loss of $1.90.

Before You Begin...

In conclusion, traders embarking on this option-trading journey should consider stocks with a history of volatility and a potential "technical trigger" on the calendar, since the short call butterfly requires a significant price swing to profit. However, while the beauty of this option play lies in the limited risk, and the fact that it doesn't require an accurate prediction of the stock's future trajectory, some investors may be turned off by the limited profit potential. If this is the case, more cash-hungry option speculators should consider similar volatility plays like the long straddle, long strangle, or long guts.