Discussion in 'P1.T3. Financial Markets & Products (30%)' started by kwadwo69, Nov 7, 2011.

Hi David. Just wondering: why would an investor choose a butterfly spread over a straddle write if the expectation is that the stock price movement would be minimal? Purely risk considerations? And why would the reverse happen, i.e. an investor chooses a straddle write over a butterfly spread?

2. ### David Harper CFA FRMDavid Harper CFA FRM (test)

Since that would be a great practice question, and i had no idea without researching it (really, I sometimes get a question that baffles me, which is fun!), I entered into the XLS for comparison. FYI, http://db.tt/aQeIwAWU

* In common: both are short volatility trades and max payout if stock remains range-bound
* Difference in initial setup: long butterfly has a small COST; short straddle generates significant INCOME (2 option premiums)
* Upside is capped for both but higher for straddle. For butterfly, upside capped at [difference between strikes and net cost; in my XLS, $2 - 0.37 =$1.63);
* Downside for long butterfly is CAPPED (at initial cost!), but unlimited for short straddle

So, this is interesting to me, at first glance i'd summarize the difference as: although both are short volatility (aka, sideways strategies) with CAPPED upside, the straddle is higher-risk/higher reward due to (i) it collects initial income and has higher upside, but IMPORTANTLY (ii) you pay for this with unlimited downside, compared to the long butterfly which has a downside limited to the initial cost.

... on a personal note, i can't imagine writing a straddle, it just looks SCARY to me with downside in both directions (yikes!). Between these two, the butterfly looks a lot more appealing to me

Thanks, David