Butterfly Spreads vs. Straddle Writes

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

  1. kwadwo69

    kwadwo69 New Member

    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 FRM

    David Harper CFA FRM David Harper CFA FRM (test)

    Hi kwadwo,

    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

    Summary comparison of long butterfly spread vs short (write) straddle:

    * 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
  3. kwadwo69

    kwadwo69 New Member

    Thought so too (writing a straddle IS indeed scary). Good insight and reinforcement of the point! Thanks.

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