The terminology used in the world of options strategies can sometimes sound more like fairytale speak than legitimate investment language. Behind these fanciful terms are real tools and strategies that have the potential to help currency traders and businesses protect themselves against foreign exchange rate risks. Notable among these strategies is the so-called “butterfly spread,” which is generally regarded as a neutral position strategy.
In its basic form, the butterfly spread is a strategy that is unique to options trading. A basic butterfly spread involves buying one call option (a call option gives the holder of the option the right to purchase the underlying asset or commodity at a specified price on a particular date, regardless of the market price on that date) at a specific call price, while at the same time selling two call options at a higher strike price, and then buying one more call option at a higher strike price than the previous two call options.
It is also possible to replicate the same effect via put options. A put option gives the holder of the option the right to sell the underlying asset or commodity at a specified price on a particular date, regardless of the market price on that date. Using put options requires buying one put option at a specific strike price, selling two put options at a lower strike price and buying one additional put option at a lower strike price than the two other put options.1
By establishing this position, it is possible to create a profit range within which the position may realize a profit over a period of time. This type of position has a limited amount of risk, on the upside and downside, and that risk is limited to the amount used to enter into the position (the cost of the put or call options). While the risk is limited, so is the profit, which will be realized so long as the underlying asset price stays in a range between the strike prices of the call or put options at the time those options expire.2
Mitigating Exchange Rate Risk
Exchange rate risk and currency risk can be mitigated by using butterfly spreads.3 By using a butterfly spread, consisting of a bull spread and a bear spread (of call options or put options), exchange rate risk and currency risk can be limited by having a maximum profit limit and a minimum loss limit. In the case of a long butterfly spread, the maximum amount of profit is obtained when the price of the underlying currency reaches the middle strike price (the strike price of the middle option) upon expiration. The break even point, on the upside of the butterfly, is the delta between the highest strike price on the high side option, and the net cost of purchasing the options. The break even point, on the downside of the butterfly, is the delta between the lowest strike price on the low side option, and the net cost of purchasing the options. The maximum possible loss is the total premium paid on the options.4
For a short butterfly spread, the maximum profit is the total premium paid for the options. This maximum profit occurs when the price of the underlying currency trades outside the boundaries of the upper and lower strike prices at expiration date. The break even point on the upside of the butterfly is the delta between the strike price of the highest option, and the total credit received for the options. The break even point on the downside of the butterfly is the sum of the strike price of the lowest option, and the total credit received for the options. The maximum possible loss is realized when the price of the underlying currency achieves the price of the strike price of the middle option at expiration.5
As an example of how to mitigate exchange risk, observe how a long call butterfly can be utilized:
On April 1st, the Great Britain Pound (the Pound) is trading at an exchange rate of GBP1.00 to US$1.40. An options trader executes a long call butterfly by buying a June call at US$1.30 for US$1,100; and writing two June calls at US$1.40 for US$400 each, and buying one more June call at US$1.50 for US$100. At this point, the options trader has a net debt of US$400 (US$400 + US$400 – US$1,100 – US$100 = US$400). This US$400 is the options trader’s maximum possible loss. In our example, when the options expire in June, the Pound is still at an exchange rate of GBP1.00 to US$1.40. The June calls at US$1.40 and US$1.50 expire as worthless (as there is no reason to exercise the call option at US$1.40 or US$1.50, as GBP can be purchased on the open market for the same exchange rate (in the case of the US$1.40 option) or even less than the strike price (in the case of the US$1.50 option)). However, the June call will still have an intrinsic value of US$1,000. From this amount is subtracted the net debt taken on to execute the long call butterfly, US$400, and the profit which results is US$600 (the maximum possible profit). On the other hand, the maximum possible loss is realized if the Pound drops below an exchange rate of US$1.30, or climbs above an exchange rate of US$1.50. If the exchange rate drops to US$1.30 or lower, all of the options expire as worthless, and the loss is the net debt taken to enter into the long call butterfly. If the exchange rate climbs to above US$1.50, the profit realized from the two long call options will be offset from the loss from the two short call options.6 Here again, the options trader’s maximum loss the net debt taken to enter into the long call butterfly.7
While using futures, options and butterfly spreads can be useful in mitigating and managing currency risk, it is worth noting that these strategies come with their own set of risks, and understanding these risks can help companies make informed decisions around currency and exchange rate risk strategy.