Short Call Butterfly Option trading strategy

In the context of Indian equities—such as stocks listed on the NSE or BSE—this strategy proves particularly useful during events that can lead to sharp price swings. Examples include monetary policy decisions by the Reserve Bank of India (RBI), quarterly earnings releases, Union Budget announcements, or geopolitical developments influencing foreign institutional flows.

What is a short call butterfly option strategy?

The short call butterfly option is a four-legged, non-directional strategy that profits when the underlying asset’s price moves sharply in either direction. It is constructed by combining both long and short call positions with varying strike prices, all sharing the same expiration date.

The structure is intentionally designed to create a “butterfly” payoff pattern, where losses are maximised if the price remains stagnant near the middle strike, and profits increase as the price moves strongly away from the central zone. Thus, it is a volatility-based strategy rather than a directional one.

Components of the short call butterfly spread

To construct a short call butterfly spread, traders enter into four call option positions as follows:

1. Buy 1 In-the-Money (ITM) call option
2. Sell 2 At-the-Money (ATM) call options
3. Buy 1 Out-of-the-Money (OTM) call option

Each of these legs has the same expiry date, ensuring symmetry and consistency in time decay behaviour. The strike intervals between the ITM and ATM, and between the ATM and OTM options, must be equidistant to maintain the traditional butterfly structure.

This design ensures that the strategy’s risk and reward are well-defined and can be calculated precisely before entering the trade.

How the short call butterfly strategy works

The short call butterfly strategy works on the principle of exploiting market volatility. It yields the highest profit when the underlying stock price moves decisively outside the upper or lower strike levels at expiration. Conversely, if the stock price closes near the middle (ATM) strike, the strategy incurs its maximum loss.

Traders adopt this setup when they anticipate that the underlying asset will experience significant movement, but the direction of that movement remains uncertain. Thus, it is commonly employed ahead of key events that could trigger substantial market reactions.

Understanding the payoff structure

The short call butterfly payoff resembles an inverted bell curve, reflecting maximum profit at the wings and maximum loss at the body. The payoff at different price levels can be summarised as follows:

Essentially, the strategy performs best when the stock price moves outside the wings, either upward or downward, by expiry. If it remains stagnant around the ATM strike, the trader faces the greatest loss.

Short call butterfly option example (Indian stock)

Let us consider a practical example involving HDFC Bank, a well-traded Indian stock.

Suppose HDFC Bank is trading at ₹1580. A trader constructs a short call butterfly using the following legs:

• Buy 1 ITM Call at 1540 CE
  Sell 2 ATM Calls at 1580 CE
• Buy 1 OTM Call at 1620 CE

Here, all options expire on the same date, and the distance between strikes is ₹40. This setup ensures symmetry, forming a balanced butterfly spread.

If HDFC Bank’s price rises above ₹1620 or falls below ₹1540 by expiry, the strategy will be profitable. However, if it stays around ₹1580, the position will incur the maximum loss.

How to calculate profit and loss in a short call butterfly

The profit and loss dynamics of the short call butterfly can be determined mathematically as follows:

• Maximum Profit
  = Net premium received
  (occurs when the underlying closes beyond the wings, i.e., below the lower or above the upper strike)
• Maximum Loss
  = (Difference between the middle and lower strike) – Net premium received
  (occurs when the underlying closes exactly at the middle strike)
• Breakeven Points

  • Lower Breakeven = Lower Strike + Net Premium Received
  • Upper Breakeven = Higher Strike – Net Premium Received

Max Loss=(K2​−K1​)−Net Premium

Breakevens=K1​+Net Premium,K3​−Net Premium

This allows traders to quantify potential outcomes and align them with their risk appetite before execution.

Advantages of the short call butterfly strategy

1. Limited risk exposure
   The maximum loss is predefined, providing clarity and control over potential downside.
2. Defined profit potential
   While limited, profits are well-calculated and realised when the underlying makes a strong move.
3. Capital efficiency
   Since the maximum loss is capped, margin requirements are comparatively lower than naked option positions.
4. Favourable in volatility
   The strategy benefits when implied volatility expands or when large movements occur unexpectedly.
5. Strategic flexibility
   The structure can be adjusted easily to adapt to changing market expectations.

Disadvantages and risks involved

1. Limited reward potential
   Profits are capped, and only realised when the stock moves significantly beyond either wing.
2. High transaction costs
   With four legs, brokerage, exchange fees, and taxes can accumulate, impacting net returns.
3. Loss during low volatility
   If the underlying price remains stagnant, the strategy incurs the maximum loss.
4. Complex execution
   The multi-leg nature requires precise entry timing and may demand adjustments during volatile sessions.
5. Sensitivity to time decay
   Theta can erode profits quickly if price movement does not occur as expected.

When to use the short call butterfly spread

This strategy is best suited in conditions where substantial price movement is expected but direction is uncertain. Typical scenarios include:

• Event-driven trading: Ahead of significant macroeconomic or corporate events such as RBI announcements, company earnings, or the Union Budget.
• Breakout anticipation: When a stock trades within a tight range and technical indicators suggest a breakout.
• Low implied volatility phase: Entering the position when volatility is low but expected to rise ensures that premiums expand, benefiting the trader.

Adjustments and exit strategies

Managing a short call butterfly spread effectively requires vigilance and adaptability. Traders can employ the following techniques:

1. Leg adjustment
   If the price approaches one wing, traders may roll the strikes or close one side of the spread to lock in partial gains or reduce risk exposure.
2. Early exit
   Exiting before expiry is advisable if the profit target is achieved early or if unexpected market developments threaten the anticipated move.
3. Stop-loss discipline
   Setting a stop-loss level based on net premium erosion or delta exposure helps in preserving capital.
4. Rolling to next expiry
   If volatility expectations remain valid but time is insufficient, rolling to a later expiry can sustain exposure with controlled cost.

Short call butterfly vs. long call butterfly

The choice between the two depends on the trader’s volatility outlook. While the long butterfly profits from stability, the short butterfly is a volatility play.

Common mistakes to avoid

1. Neglecting transaction costs
   Ignoring brokerage, GST, and exchange fees can misrepresent the true profitability of the trade.
2. Improper strike selection
   Selecting uneven strike distances disrupts the symmetric payoff, altering risk-reward balance.
3. Entering during low volatility
   Initiating the trade when volatility is already compressed often results in losses if the expected breakout does not occur.
4. Failure to monitor positions
   Not adjusting or closing legs when the market moves significantly can result in missed opportunities or expanded losses.
5. Overexposure to a single stock
   Concentrating too much capital in one setup amplifies event risk and undermines portfolio balance.

Conclusion

The short call butterfly option strategy is a refined tool for traders operating in the Indian stock market who seek to profit from heightened volatility while maintaining defined risk parameters. It exemplifies disciplined trading through structured risk management and a calculated reward profile.

When executed with sound judgment, the short call butterfly spread allows participants to engage effectively in uncertain markets, particularly before major events that could trigger significant price swings.

However, success with this strategy demands precise timing, prudent strike selection, and strict adherence to risk controls. Transaction costs, liquidity considerations, and event timing must all be accounted for before deployment.Ultimately, the short call butterfly strategy is not merely a volatility play—it is a lesson in patience, balance, and precision. Traders who respect its structure and manage it diligently can leverage it as a powerful component of a broader options trading portfolio.