An advanced options strategy with three legs and four total options is called a long butterfly spread with calls. One call is purchased at strike price A, two calls are sold at strike price B, and one call is subsequently purchased at strike price C. The set up results from an investor linking the beginning of a short call spread with the end of a long call spread at strike price B.
An investor who opens this position is making a wager that the stock will pin or almost pin at strike price B. The investor would keep the profits from option A if the stock did really pin at the short strikes, but options B and C would expire worthless.
Although it can be difficult to secure that pinning strike, this method has a modest entrance cost, which means decreased risk if things go south. The long butterfly spread works well in low-volatility situations where there is a good chance that the price will pin. Due to its limited loss, it can also be a wise decision in volatile markets, but traders should watch the trade carefully and exit it as the stock goes near the short strikes.
Profit/Loss
The difference between the lowest and middle strike prices is subtracted from the cost of the trade to determine the maximum profit. For instance, the maximum profit would be Rs 4.30 if the distance between points A and B were Rs 5 and the deal cost Rs 0.70.
The maximum loss would be equal to the cost of the deal, or Rs 0.70 in the same scenario.
Breakeven
There are two points where things break even. By taking the lower strike price (point A) and adding the trade’s cost, one can get the lower breakeven point. So, if transaction cost Rs 0.70 and point A had a strike price of 100, the lower breakeven would be Rs 100.70.
The highest strike price (point C) would be used to determine the higher breakeven point, and the net debit would be subtracted. Therefore, our higher breakeven would be Rs 109.30 if the point C strike price was Rs 110 and the transaction cost was Rs 0.70.
Example
A trader might execute a 100/105/110 butterfly spread by purchasing one call with a strike price of 100, selling two calls with a strike price of 105, and purchasing one call with a strike price of 110 at the prices listed below:
- Purchase one (Rs 5.00) XYZ 100-strike price call.
- For Rs 5.40 (Rs 2.70 each), sell two XYZ 105-strike price calls.
- Purchase 1 110-strike price call for XYZ for Rs 1.10.
- Cost in whole is Rs 0.70 debit.
The investor will have lost the full Rs 0.70 if the stock declines during the next 45 days, and all positions will expire worthless and be taken out of the account.
The trader will profit Rs 5 if the stock moves up slightly to Rs 105 at expiration, capitalising on the 100-strike price option while the other options expire worthless. Their net gain would be Rs 4.30 because they spent Rs 0.70 on the trade.
The investor would profit Rs 10 on the 100 call if the stock reached a price of Rs 110. The 110 call expired worthless, resulting in a loss of Rs 10 (Rs 5 X 2 losses on the short middle 105-calls). The investor paid Rs 0.70 for the trade, therefore their net loss is Rs 0.70. The final result would be Rs 10 – Rs 10, meaning all profits are lost.
Conclusion
A butterfly spread with calls becomes more bullish and less expensive to trade the higher the strike prices are set by the trader. However, the likelihood of winning decreases when strike prices are raised.
The implied volatility is sensitive to variations in this kind of spread. Inversely correlated with changes in implied volatility is the spread’s net price, which decreases when implied volatility increases and rises when implied volatility decreases. The trader who places this order hopes implied volatility would decrease.
The long butterfly spread with calls is a technique that should only be used by seasoned options traders.
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