Construction
It is the opposite of the long call butterfly. The strategy involves three different strikes and it consists of a short ITM call, a short OTM call and two long ATM calls. The two short calls strikes should be equidistant from the middle long calls strike.
It is a credit spread because the money we earn from the short calls is more than the money we have to pay for the long calls.
When to use
When we expect that the price of the underline security will move in either direction at least at or beyond the short calls strikes. Preferably we want the underline security to be at or above the higher OTM strike or at or below the lower ITM strike in order to achieve maximum profit, which is limited to the net premium received. Maximum potential loss occurs when at expiration the price of the stock is exactly at the middle ATM strike.
If the stock price at expiration is below the lower strike all options expire worthless and we have the full net premium received as profit, minus commissions. Above the higher strike the two short calls are exercised against us but the losses are fully counter-weighted by the two long calls at the middle, so we have again the full net premium received as profit.
Loss/Profit at expiration
Maximum loss: (Middle strike price – lower strike) + net premium received – commissions.
Maximum profit: Net premium received – commissions.
Profit/Loss diagram
Below we can see the profit/loss diagram for the short call butterfly strategy. We are short one ITM call with strike $22 and premium $3.50, one OTM call with strike $28 and premium $0.50 and long two ATM calls with strike $25 and premium $1.
Short call butterfly strategy example
In the daily chart of stock VZ (below) we believe that due to high market volatility, the price of the stock will break the support (line 1) or the resistance (line 2) in a two months period. The stock is already consolidating for a long period of time. When the price is at point A we can apply the short call butterfly strategy by writing one ITM call with strike $36 and premium $2.50 and one OTM call with strike $40 and premium $0.50 and purchase two ATM calls with strike $38 and premium $1. All the options are expiring in about two months. The net premium received for the opening of the position is $100 {[($2.50+$0.50)-(2x$1)]x100}.
If the stock price at expiration is exactly $38 (ATM strike) then we have the maximum possible loss (without estimating commissions), which is the middle strike minus the lower strike, multiplied by 100 minus the net premium received, meaning $100 {[($38-$36)x100]-$100}.
If the stock at expiration is at or above the higher strike i.e. at $45, then we are losing $9/share because the short ITM call is exercised against us. We are also losing $5/share from the short call with the higher strike ($40) which is also exercised against us but we are winning $14/share from the two long calls with strike $38 [($45-$38=)x2=$14/share]. So, the total loss is equal to the total profit and what remains in the end is the net premium received.
If the stock at expiration is below the lower strike then all options are worthless and our profit again is equal to the net premium received.