Long butterfly with calls

The long butterfly call spread is created by buying one in-the-money call option with a low strike price, writing two at-the-money call options, and buying one out-of-the-money call option with a higher strike price. As a result, a net debit spread is created, which means a trader pays upfront to enter a trade with this strategy. Usually, the spread is of $5 on either side of the at-the-money strike price. However, the expiry remains the same. But why multiple buying and selling of options. The answer is simple, to minimize the risk. The 2nd leg of writing two contracts hedge against a significant movement on the bearish side and the 3rd leg of buying a contract reduces the risk on the bullish side. The working of this strategy will be a lot clearer in the subsequent sections of this article.

Trading with MS excel

Below is a screenshot of the complete excel template that marketXLS provides for this strategy. This template has five major components. Let’s break them down one by one.

Input by user

In this section, you put the stock ticker and the expiry for the option of that underlying. You can select the expiry from section 2. Here, we have taken the example of MSFT (Microsoft Corporation) with an expiry of 19 Feb 2021.

Execution

Long butterfly with call involves three legs- buying, selling, and again buying contracts in the ratio 1:2:1. As I am writing this article, MSFT shares are trading at around $244. Hence, the first leg will be $5 lower than the ATM strike, which is about $240, and the 3rd leg will be $5 higher than the ATM strike, which is $250. As a result, a net debit spread of $223 is created, which the trader will pay to open this trade. This will be the highest loss a trader will incur in this trade.

Profit, loss, and breakeven

Below is an analysis of how the payoffs would pan out at different prices of the underlying. As you can see from the picture, the maximum loss is limited to $223. This wouldn’t have been the case if only one of the legs was exercised. If only leg 1 was executed, the losses would have been humongous on the bearish side. The induction of leg 2 negated the losses on the bearish side, but it only amplified the bullish side’s losses. Buying of a contract in leg 3 balanced the losses across all the prices of MSFT. The maximum profit is when the stock doesn’t make any movement, which is $227. The breakeven points are around $242 on the bearish side and $248 on the bullish side.

Key takeaways

• Instead of just buying a contract, a long butterfly involves two more legs to minimize the risk on both the bearish and the bullish side. Basically, it balances the risk to a fixed amount.
• The long butterfly is a low volatility strategy. It is preferred when a trader expects the price of a stock to stay around the strike price. This is when a trader gains the most from this strategy.
• This strategy is not suitable for beginners as it involves multiple legs execution and the possible loss is also relatively high.
• In this strategy, both the maximum profits and the losses are limited
• A net debit spread is created in this strategy, meaning there will be a cash outflow to open a trade.

Disclaimer

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The author is not offering any professional advice of any kind. The reader should consult a professional financial advisor to determine their suitability for any strategies discussed herein.

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References

Learn more about long butterfly here.