Long Call Butterfly

The Long Call Butterfly is an advanced options trading strategy that is used when a trader expects little to no movement in the underlying asset's price. It's a strategy that combines both bullish and bearish outlooks with limited risk and is designed to profit from a stock trading at or near a particular target price at expiration.

The Setup

Consider a stock, XYZ Corp, currently trading at $50. To set up a long call butterfly, you might 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 options have the same expiration date. The total cost of setting up this trade (net debit) is $1 ($7 + $2 - $8).

Who Should Consider It

This strategy is suited for traders who expect the stock price to be near a certain level at expiration and desire a position with defined and limited risk. It's ideal for market environments with low volatility where the stock price is anticipated to change little.

Strategy Explained

In a long call butterfly, the two sold calls at the middle strike price help 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 maximum value while the others expire worthless or with minimal value, maximizing profit.

Max Profit Potential

The maximum profit is limited and occurs if the stock price is exactly at the middle strike price at expiration. It is calculated as the difference between the middle and lower (or upper) strike prices minus the net debit. In this case, 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, occurring 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 establish the butterfly.

Risk

The main risk involves the stock price moving significantly away from the middle strike price. However, since the maximum loss is capped at the net debit paid, this strategy remains attractive for its limited downside.

Time Decay

Time decay (theta) is beneficial to this strategy as expiration approaches, provided 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 decrease in implied volatility is generally favorable for this strategy after it is set up. Lower volatility reduces the likelihood of the stock price moving significantly, which is favorable for a butterfly spread.

Conclusion

The Long Call Butterfly is a cost-effective strategy for traders who predict that a stock will remain at or near a specific price by expiration. It offers well-defined risk and reward, making it a conservative choice for traders looking to profit from minimal price movement in the underlying asset.