Long Call Butterfly Options Strategy
What is a Long Call Butterfly Strategy?
The long call strategy is for traders who see a very minimal movement of trading prices in the market and can safely vouch that the underlying would remain the same at expiry. For instance, an investor analyzes the market, sees the 52-week record and finds that the trading prices have not changed significantly. Then he might predict that this trend will continue, and he implements a long call butterfly strategy.
A long call butterfly is a three-leg options strategy that simultaneously purchases and sells calls. The short and long strikes must be equidistant from the middle strike price. Of course, all the options have the same expiration cycle in the long call butterfly strategy. Thus, the long call butterfly strategy is a neutral one. It is a clever strategy of combining a bull spread and bear spread, implemented when volatility is low.
A bull spread is a strategy applied in a bullish market, where an upwards trend is noticed in the underlying. It consists of the simultaneous selling and buying of either call or put options, where the options have the same expiration date. A bear spread options strategy is implemented in a bear market, where a downwards trend is observed in the underlying. This strategy also consists of purchasing and selling call or put options, where the options have the same expiration cycle.
A long call butterfly strategy is a favourite among options traders seeking limited risk. However, it is also significant to keep in mind that the maximum profit from this strategy is also capped. Let us look at the long call butterfly strategy from different perspectives.
Basic Overview
Let us take a study case of Nifty 50 and assume that the stocks of Nifty 50 have been trading around the same price for quite some time. How do you benefit from such a market? As an investor, in such circumstances, you can benefit by correctly guessing the stock price at expiration and sell calls at that strike price. A long-call butterfly strategy will only work if the stock price remains within a very narrow range.
Technical Perspective
In the case of a volatile market, it is not possible to predict the price at which stocks will close at expiration. But if you observe the stock prices over a long time (standard time of 52 weeks) and see that it has been chiefly moving within a tight range, you might predict at what price it will trade after a short period.
Quantitative Approach
A long call butterfly options strategy works the best for a low volatile market. It works the best to protect your interests as the maximum profits are predefined. The maximum loss that you can face is limited too.
Policy Note
A long call butterfly approach is prevalent among options traders seeking profits at limited risks. This strategy entails three steps in the ratio 1-2-1. A long call strategy comprises buying one ITM (in the money) call, selling two ATM (at the money) calls, and buying one OTM (out of the money) call. The upper and lower strike prices (wings) are central to the medium strike price (body).
A key consideration for this strategy is that all the options must have the same expiration cycle. Therefore, this strategy is only plausible if the market trend is potentially non-volatile and you can safely predict the trading price of the stocks at expiration. Maximum possible profit- The maximum profit made through this strategy can be calculated as: the difference between two adjacent strike prices (lowest and middle strikes) less the net premium debit (including the commissions). It is only achieved when the stock price closes at the centre strike during expiration.
Maximum possible loss- It is equal to the net premium debit paid. You can incur losses during two scenarios: when the stocks expire at a price lower than the lowest strike price, all the calls become worthless, and the net premium paid is lost. If the stock price closes above the highest strike price, the net profit is zero. The upper break-even point is calculated as the highest strike price less the net premium debit. The lower break-even point is calculated as the lowest strike price plus the net premium debit.
When To Apply Long Call Butterfly Strategy?
Let’s take the example of Nifty 50 to understand the workings of this strategy. The spot price of Nifty 50 is INR 17500. The lot size is 50. An investor sees that the Nifty 50 has been consistent in its trading performance and assumes that the stock prices will not deviate much during expiration. He applies a long call butterfly strategy. He buys an ITM call of INR 17300 at INR 250 and an OTM call of INR 1770 at INR 85. He simultaneously sells 2 ATM calls of INR 17500, at INR 140 each.
| Strike Price | Premium | Total Premium (Premium*Lot size) | |
|---|---|---|---|
| Buy 1 ITM Call | 17300 | 250 | 12500 |
| Sell 2 ATM Call | 17500 | 140*2 | 14000 |
| Buy 1 OTM Call | 17700 | 85 | 4250 |
Net Premium= (250-280+85)= 55
Total Premium Paid= (12500-14000+4250)= 2750
Upper break-even= 17700-55= 17645
Lower break-even= 17300+55= 17355
Maximum Possible Loss= 2750
Maximum Possible Profit= ((17500-17300)-55))*50= 7250
Note- All the figures are in Rs unless stated otherwise.
Let us look at a long call butterfly strategy table for better clarification.
| Closing Price of Nifty 50 | Profit/Loss from 1 ITM Call bought at 17300 | Profit/Loss from 2 ATM Calls sold at 17500 | Profit/Loss from 1 OTM Call bought at 17700 | Total Profit/Loss |
|---|---|---|---|---|
| 17200 | (12500) | 14000 | (4250) | (2750) |
| 17300 | (12500) | 14000 | (4250) | (2750) |
| 17400 | (7500) | 14000 | (4250) | (2750) |
| 17500 | (2500) | 14000 | (4250) | (2750) |
| 17600 | 2500 | 4000 | (4250) | (2750) |
| 17700 | 7500 | (6000) | (4250) | (2750) |
| 17800 | 12500 | (16000) | 750 | (2750) |
Perks of Long Call Butterfly Strategy
A long call butterfly approach is popular among options traders and for the right reasons.
- The maximum possible loss that can be incurred from this strategy can be precalculated, and hence you can adjust the entire process according to your risk appetite.
- It is a great way to earn money from a market that is not showing significant movements.
Disadvantages of Long Call Butterfly Strategy
There are some disadvantages to this options strategy that must be considered before you implement a long call butterfly to your options trading scheme.
- The net profits are significantly capped.
- There are three legs to the strategy. Commissions are charged at every step while opening and closing the options. This makes the entire process of the long call butterfly strategy costly. Therefore, buying and selling calls at the correct strike prices is crucial to see good profits.
- Long Call Butterfly strategies are susceptible to the volatility of the market.
- There is the possibility of losing out 100% of the cost of the premium debit in case the stock price goes beyond the lowest or the highest strike prices. Hence, as an investor, you must be vigilant and close your bids in such a situation to avoid heavy losses.
Wrapping Up
This strategy is a good option only when an investor is sure that the underlying value of the stocks will not move significantly within a period. A long call butterfly strategy is a limited risk one, and its success depends on the fact that the stock prices must remain within the lowest and highest strike prices at the time of expiration. Thus, this strategy has a limited downside risk and upside reward.