Question

A butterfly spread is the purchase of one call at exercise price X1, the sale of two calls at exercise price X2, and the purchase of one call at exercise price X3. Then X1 < X2 and X2 < X3 by equal amounts, and all the calls have the same expiration date. Let’s use a few numbers to make our calculations and graph more transparent. Suppose we are buying one call at X1 = $50, writing two calls at X2 = $65, and buying one call at X3 = $80.

(a) Describe the payoff to this strategy.

(b) Graph the payoff versus stock price at expiration.

(c) In what circumstance might someone use this strategy? In other words, what against kind of risk does this strategy protect?

Answer 1

see the solution in screenshot attached