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Reducing Call Spread Risk by Converting It to a Butterfly

Article Quant Q&A · Author: Victor123
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Summary

The note explains how an initially risky debit spread or long option position may be reshaped into a butterfly after the underlying moves favorably. The trader adds option legs, buying and selling contracts so the combined position has the butterfly structure. If those trades generate a credit, it can offset some or all of the original debit, reducing the amount at risk in the position.

The conversion depends on favorable movement after opening the initial trade and on being able to establish the new legs at a sufficient credit. The note offers no worked example, pricing analysis, or discussion of execution costs, so it does not establish that the adjustment will be available or eliminate risk in every case. Its explanation is a concise conceptual description rather than a complete trading procedure.

Key ideas

  • A debit spread or long option position may be converted into a butterfly by adding option legs.
  • The underlying must move favorably before the conversion can offset the initial cost.
  • A credit from the added trades can reduce or potentially recover the original debit.
  • The amount of risk reduction depends on the prices available when adjusting the position.

Tags

OptionsDerivatives pricingRisk management
Full text
# Convert a call spread to a butterfly to mitigate risk


# Convert a call spread to a butterfly to mitigate risk












I do not have a source for this (apologies), but sometimes, I hear about option traders initiating a vertical spread(short) and then converting that call spread to a butterfly spread to mitigate risk.

I understand the different legs of a butterfly, but it is not obvious to me how morphing a vertical call spread to a butterfly call spread helps reduce the risk ?

## Answer by baerrus (score 1, accepted)

https://quant.stackexchange.com/a/16826

Conversion to a butterfly can mitigate or even eliminate all risk taken by opening a initial debit spread or long option position. This is possible only if the underlying moved in your favor after your initial position is open. To convert to a butterfly you simply sell and buy enough options (for a credit) that together with your initial position forms a butterfly. The credit taken in offsets all or most of your debit to open the initial position. Thus your risk is eliminated. This technique is a staple used by all Market Makers. For a specific example of a trade which ends up converted to a butterfly with charts see converting options spread to butterfly. (disclosure: I am affiliated with the site)

PS: Quant is not place for trading related questions. This is mostly a place for people to geek out about options.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.