The Long Call Butterfly is an options trading strategy that involves using multiple call options to profit from a narrow range of price movement in the underlying asset. It is a neutral strategy, meaning it can be profitable when the underlying asset’s price remains relatively stable within a specific range. Let’s break down the Long Call Butterfly strategy in simple terms:
1. How the Long Call Butterfly Works:
- The Long Call Butterfly strategy combines three call options with the same expiration date.
- It involves buying one at-the-money (ATM) call option (usually with a strike price close to the current market price), selling two out-of-the-money (OTM) call options with higher strike prices, and buying one further OTM call option with an even higher strike price.
- The strategy’s goal is to profit from minimal price movement in the underlying asset.
2. Scenario 1: Minimal Price Movement (Profit Zone):
- If the underlying asset’s price remains within a specific range at expiration, the Long Call Butterfly can be profitable.
- The maximum profit occurs when the underlying asset’s price is close to the middle strike price (the two sold call options).
3. Scenario 2: Price Moves Significantly (Loss Zone):
- If the underlying asset’s price moves significantly in either direction, the strategy may result in a loss.
- The maximum loss occurs when the underlying asset’s price is outside the range defined by the two sold call options.
4. Example of Long Call Butterfly:
Let’s consider an example with fictitious stock XYZ, which is currently trading at $100.
- Buy 1 XYZ Call Option with a strike price of $100 (ATM) for $5 premium per share.
- Sell 2 XYZ Call Options with a strike price of $110 (OTM) for $2 premium per share each.
- Buy 1 XYZ Call Option with a strike price of $120 (further OTM) for $1 premium per share.
Profit and Loss Scenarios at Expiration:
- If XYZ remains between $108 (middle strike) and $112 (strike prices of the two sold options), the strategy is profitable.
- If XYZ is below $108 or above $112 at expiration, the strategy results in a loss.
Benefits of Long Call Butterfly:
- Limited risk: The maximum loss is limited to the initial premium paid to enter the trade.
- Low cost: Compared to some other strategies, the Long Call Butterfly has a relatively lower upfront cost.
Risks of Long Call Butterfly:
- Limited profit potential: The maximum profit is limited to the difference between the strike prices of the two sold call options, minus the net premium paid.
Conclusion:
The Long Call Butterfly is a neutral options strategy designed to benefit from minimal price movement in the underlying asset. It involves buying and selling multiple call options to create a profit zone within a specific price range. While the strategy has limited profit potential, it also comes with limited risk, making it a suitable choice for investors who expect the underlying asset’s price to remain relatively stable.