Long Call Butterfly

The Long Call Butterfly Setup

Assume a stock, XYZ Corp, is trading at $50. To set up a long call butterfly, you can choose to:

• Buy one in-the-money call option with a strike price of $45 for $7.
• Sell two at-the-money call options with a strike price of $50 for $4 each.
• Buy one out-of-the-money call option with a strike price of $55 for $2.

All the options expire on the same date. The amount of money needed to set up this trade (net debit) is $1 ($7 + $2 - $8).

Who Should Consider It

This strategy is ideal for traders who expect the stock price to be at a specific level at expiration and desire a position with defined and limited risk. It’s ideal for market conditions with low volatility where the stock price is expected to move little.

Strategy Explained

In a long call butterfly, the two sold calls at the middle strike price help to offset the cost of the bought calls at the lower and higher strikes. The goal is to have the stock’s price close at the middle strike price at expiration, where the maximum profit is achieved.

Breakeven Process

There are two breakeven points for this strategy:

• Lower breakeven: Lower strike price + net debit.
• Upper breakeven: Higher strike price - net debit.

For XYZ Corp, the breakeven points would be:

• $45 + $1 = $46
• $55 - $1 = $54

Sweet Spot

The sweet spot for this strategy is precisely at the middle strike price at expiration ($50 in this example). Here, the middle strike call options expire at their peak value while the others expire worthless or with minimal value, maximizing profit.

Max Profit Potential

The maximum profit is limited and is achieved if the stock price is precisely at the middle strike price at expiration. It is the difference between the middle and lower (or upper) strike prices minus the net debit. In this example, maximum profit would be:
$5 (difference between $50 and $45) - $1 (net debit) = $4 per share.

Max Loss

The maximum loss is the initial net debit paid to enter the trade, achieved if the stock is below the lower strike or above the higher strike at expiration. Here, the maximum loss would be $1 per share, the amount paid to construct the butterfly.

Risk

The main risk is the stock price moving far from the middle strike price. However, since the maximum loss is limited to the net debit paid, this strategy is attractive for its limited downside.

Time Decay

Time decay (theta) is beneficial to this strategy as expiration approaches, assuming the stock price is near the middle strike price. This is because the value of the short call options (middle strike) decays faster than that of the long calls.

Implied Volatility

A reduction in implied volatility is generally beneficial to this strategy once in place. Lower volatility makes it less probable for the stock price to move far, which is beneficial for a butterfly spread.

Conclusion

Long Call Butterfly is a low-cost strategy for those who anticipate that a stock will remain at or near a specific price at expiration. It is a precisely defined risk and reward strategy, hence a conservative strategy for such traders who anticipate profiting from minor price movement in the underlying.