In the above example:
- Buy 1 Call strike 95
- Sell 2 Calls strike 100
- Buy 1 Call strike 110
The position may be established for a net debit or a net credit, and both the potential profit and maximum risk are limited.
Strike prices are equidistant, and all options have the same expiration month.
Risk is limited to the net debit paid: after the trade is paid for, no additional margin is required.
A skip strike butterfly with calls is more of a directional strategy than a standard butterfly. Ideally, you want the stock price to increase somewhat, but not beyond strike 100. In this case, the calls with strikes 100 and 110 will approach zero, but you’ll retain the premium for the call with strike 95.
This strategy is usually run with the stock price at or around strike 95 in our example, with a slighly bullish expectation: in doing so, the stock will have to make a significant move upward before you encounter the maximum loss.
Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks.
Margin requirement is equal to the difference between the strike prices of the short call spread embedded into this strategy. If established for a net credit, the proceeds may be applied to the initial margin requirement.
Time decay is your friend. Ideally, you want all options except the call with strike A to expire worthless.
After the strategy is established, the desired changes in implied volatility depends on where the stock is relative to your strike prices.
If the stock is at or near strike 100, you want volatility to decrease. Your main concern is the two options you sold at strike 100. A decrease in implied volatility will cause those near-the-money options to decrease in value, thereby increasing the overall value of the butterfly. In addition, you want the stock price to remain stable around strike 100, and a decrease in implied volatility suggests that may be the case.
If the stock price is approaching or outside strike 95 or 110, in general you want volatility to increase. An increase in volatility will increase the value of the option you own at the near-the-money strike, while having less effect on the short options at strike 100.