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Answer: Both the upside and downside is limited.
## Explanation A butterfly spread is a **limited risk, limited reward** strategy. Let's analyze why: **Construction:** Long 1 call (X1) + Short 2 calls (X2) + Long 1 call (X3) **Risk profile:** - **Maximum loss**: Occurs when the stock price is below X1 or above X3 at expiration. All options expire worthless except for the premium paid. The maximum loss is the net premium paid to establish the position. - **Maximum profit**: Occurs when the stock price is exactly at X2 at expiration. The profit equals the difference between strike prices minus the net premium paid. **Why both are limited:** - **Downside limited**: Even if the stock price goes to zero, you only lose the initial premium paid - **Upside limited**: Even if the stock price goes to infinity, the long positions are offset by the short positions, creating a capped profit The butterfly spread is specifically designed to have defined, limited risk on both sides, making it a popular strategy for traders expecting low volatility.
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A butterfly spread involves positions in options with three different strike prices. It can be created by buying a call option with a low strike of X1; buying a call option with a high strike X3; and selling two call options with a strike X2 halfway between X1 and X3. What can be said about the upside and downside of the strategy?
A
Both the upside and downside is unlimited.
B
Both the upside and downside is limited.
C
The upside is unlimited but the downside is limited.
D
The upside is limited but the downside is unlimited.
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