A butterfly spread consists of: A. two put option contracts. B. four call option contracts. C. two call options and two put options.
I just wanted to double check that this is an errata by Schweser.
The answer suggested by the book is B but it should be B or C.
it has to be 4 call or 4 put, I believe.
buy 1 call @ Xl, sell 2 Call @ Xm, buy 1 call @ Xh
or buy 1 put @ Xl, sell 2 Put @ Xm, buy 1 Put @ Xh
cannot be 2 put and 2 call… as you are suggesting.
How about sell one call and one put at the same price
Cover it by buying one high call and buying one low put.
that becomes the definition of the box spread I believe…
one bull call spread + 1 bear put spread together. on the same asset. Hence Asset price at expiration does not matter - and you would end up with the risk free rate of return. It is not the butterfly spread…
For A butterfly - you need 3 different exercise prices.
I encourage you to try drawing the payoff diagram out.
The description I gave is essentially a short straddle with both sides covered which is the essence of butterfly.
Vt = Max (0, X1-St) - Max(0, St-X2) + Max(0, X2-St) + Max(0, St-X3)
Buy low put at X1, Sell Call at X2, Buy Put at X2 and Sell Call at X3 - position you described.
X1 < X2 < X3
At St < X1
Vt = X1 - St - 0 + X2 - St + 0 = X1 + X2 - 2St --> which does not match any thing on the payoff of the Butterfly spread seen in the curriculum.
butterfly:
buy call at Xlow
sell 2 calls at Xmedium
buy call at Xhigh
1+2+1 = 4…
B is correct, it is 4 total calls (2 bought and 2 sold)