Can someone please clarify what is the purpose of the higher strike call in a butterfly spread?
If the stock is below the higher call strike, then it expires OTM.
If the stock is above the strike of the 2 short calls, then short calls are ITM and gets called away.
Where does the long higher strike call come into play?
It protects your backside in case the price of the underlying rises substantially. You can exercise the call when it’s in the money and mitigate your loss.
As S2k said above, it covers your butt in case the stock triples and you have to deliver on one of the shorts.
Dang you’re quick.
So say the short call strike is $10 and long call higher strike is $15.
If stock goes to $30, you have to deliver the stock at $10 on the short calls but if you don’t have enough stocks available, you can buy it at $15 to deliver at $10?
Exactly. You now only lose $5.00/share instead of $20.00. Also, I would imagine that for almost any given scenario on the exam if they’re going to ask a butterfly spread question that you won’t have _ any _ stock/s held to deliver. A butterfly spread doesn’t really imply you hold any stock (whereas holding the stock is an integral part of a collar).
Awesome, thanks! This is helpful.