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2. Basics Concepts – Long Call Butterfly
Proficiency -
Intermediate
Direction – Neutral
Volatility - Low
Asset Leg –
Long Call + Two
Short Call + Long
Call
Max Risk - Limited
Max Reward -
Limited
Capital Gain
Strategies
3. Description – Long Call Butterfly
The Long Call Butterfly involves a low strike long call, two
ATM short calls, and an OTM long call.
The resulting is profitable in the event of range bound
action by the stock.
Although the risk/reward ratio is attractive, the problem is
that the maximum reward is restricted to the scenario where
the stock is at the middle strike at expiration.
Long butterflies are quite popular because they offer a good
risk/reward ratio, together with low cost.
4. Description – Long Call Butterfly
Buy one lower strike (ITM) call.
Sell two middle strike (ATM) calls.
Buy one higher strike (OTM) call.
All options share the same expiration date for this strategy.
For this strategy, you must use all calls.
Remember that there should be equal distance between each strike price.
The maximum reward occurs if the stock is at the middle strike at expiration.
5. Context - Long Call Butterfly
Outlook
With Long Call Butterfly, your outlook is direction neutral—you are
looking for no movement in the stock.
Rationale
To execute a direction-neutral income strategy for a net credit while
expecting a future decline in volatility.
Ideally you are looking for a scenario where the immediate Implied
Volatility has been high, giving you above average options
premiums, but where you anticipate the stock to consolidate
(become less volatile) and remain range bound for the duration of
your trade.
6. Context - Long Call Butterfly
Net Position
This is a net debit trade, although the net cost is
typically low.
Your maximum risk is the net debit of the bought and
sold options.
Your maximum reward is the difference between
adjacent strike prices less the net debit.
7. Context - Long Call Butterfly
Effect of Time Decay
Time decay is helpful to this position when it is profitable an
harmful when the position is unprofitable.
Time Period to Trade
Month or Less
Breakeven Down = [Lower Strike + Net Debit]
Breakeven Up = [Higher Strike - Net Debit]
8. Steps to Trading a Long Call Butterfly
Steps In
Try to ensure that the trend is range bound and identify clear areas of support
and resistance.
Try to ensure that no news is coming out soon for the stock.
Steps Out
Manage your position according to the rules defined in your Trading Plan.
If the stock veers outside your stop loss areas above or below the stock price,
then unravel the entire position.
You can unravel the position just before expiration—remember to include all
the commissions in your calculations.
9. Exiting the Trade - Long Call Butterfly
Exiting the Position
With this strategy, you can simply unravel the spread by buying
back the options you sold and selling the options you bought in the
first place.
Advanced traders may leg up and down or only partially unravel the
spread as the underlying asset fluctuates up and down.
Mitigating a Loss
Unravel the trade as described previously.
Advanced traders may choose to only partially unravel the spread
leg-by-leg and create alternative risk profiles.
10. Advantages and Disadvantages
Advantages
Profit from a range bound stock for very little cost.
Capped and low risk.
Comparatively high risk/reward ratio if the stock remains range
bound.
Disadvantages
The higher profit potential comes with a narrow range between the
wing strikes.
The higher profit potential only comes nearer expiration.
Bid/Ask Spread can adversely affect the quality of the trade.