The long call butterfly strategy is one of the many ways to employ options to benefit from a sideways market. Coming with capped losses (and, sometimes, even no losses on either the upside or the downside), call butterfly spreads are great ways to manage risk. Let us tell you more about this strategy, teach you how to read a butterfly option graph, and go through a detailed real-market trading example.
Key takeaways
- The long call butterfly strategy is a neutral options approach that combines buying and selling call options at varying strike prices to benefit from limited stock movement, offering cost-effectiveness and risk management.
- Known as a multi-leg, risk-defined strategy, the long call butterfly can yield profits in stable markets by capitalizing on reduced volatility and time decay, with the underlying asset’s price hovering near the middle strike.
What Is the Long Call Butterfly?
The call butterfly (also known as long call butterfly or call fly) is a neutral options strategy that combines buying and selling call options at different strike prices. It benefits from limited stock movement, providing cost-effectiveness and risk management. This strategy is ideal for traders looking to capitalize on the stability of an asset’s price.
To build a long call butterfly, you need to:
- Buy one lower strike call: This establishes the floor of your potential profit zone.
- Sell two middle strike calls: These calls generate income, helping to offset the cost of the long calls, and define the peak of the P&L graph.
- Buy one higher strike call: This caps your potential profit and loss, creating the ceiling of the strategy.
What about the profit and loss (P&L) of the call fly? Well, when visualizing this setup on a butterfly option graph, here is what you will see:
Notice the capped losses on both ends and the profit peak at the middle strike. This formation illustrates that maximum profit occurs when the asset price stays near the middle strike at expiration.
Setting up a call butterfly involves selecting appropriate strike prices and expiration dates. Here are the steps to follow:
- Begin by selecting a middle strike price where you anticipate the underlying asset will hover close to at expiration.
- Choose appropriate strike prices and expiration dates.
- Ensure the lower and upper strikes are equidistant from the middle point to create symmetry in the strategy.
Consider market conditions when selecting expiration dates. A shorter timeframe might be optimal if you expect minimal price movement in the near term, while a longer expiration might suit if you anticipate the asset stabilizing over a more extended period. Keep in mind that implied volatility can affect option premiums, influencing the initial cost of your butterfly spread.
Execution involves careful attention to market prices and timing. Enter the position when the combination of long and short calls is most cost-effective, typically when volatility is low. This ensures the premium paid is minimized, enhancing the potential for profitability.
Understanding the long call butterfly strategy can offer traders a structured way to engage in options trading with predefined risk. It’s essential to monitor positions and market conditions regularly, adjusting as necessary to maintain balance between the wings and achieve desired outcomes. The call fly’s simplicity and defined risk make it a popular choice for traders seeking to benefit from stable market conditions without incurring significant loss.
A Real-Market Example of the Long Butterfly
Here is an example on the long call butterfly for you. Before we start, consider this: usually, you will use the call butterfly above the stock price, and the put butterfly below. You’d do that because the bid-ask spread of the OTM options will be lower, so it will be easier to trade.
For the sake of our example, however, we won’t focus on this latter case, but we will simply take a look at textbook case.
Imagine you have a hunch that Verizon (VZ) won’t see much price movement over the next two weeks. This belief might stem from several factors: the company is not due for earnings announcements, there are no new product launches on the horizon, and these factors also apply to its main competitors.
Based on this outlook, you predict that VZ, currently trading at $41.65, will remain between $38 and $42 over the next two weeks.
Given this scenario, you could set up a call butterfly as follows:
- Buy a $38 call: This establishes the lower boundary of your profit range.
- Sell two $40 calls: These generate premium income and form the peak of your expected profit.
- Buy a $42 call: This limits your maximum potential loss and profit.
With these options expiring in two weeks, here’s the P&L profile generated by our options screener on the long butterfly strategy:
In this setup, your profit is maximized if VZ hits exactly $40 on the expiration date, netting you a potential $183 profit. You’d still see gains if VZ trades between $38.17 and $41.83. Falling outside this range results in a loss of only $16.75. The high profit ratio of this trade, where you can earn $183 in the best-case scenario against a $16.75 loss if you’re incorrect, is one of the strategy’s primary attractions.
Let’s take a closer look at VZ’s historical price performance to understand its recent trends and potential implications:
You could easily notice that VZ has frequently traded between your two breakeven points and often hovers close to the desired $40 mark over the past few months. This historical consistency can further support your decision to implement the call butterfly strategy in this context.
When assessing this approach, using a butterfly option graph helps visualize the strategy’s potential outcomes. The butterfly spread graph typically shows capped losses on both ends, with the highest profit at the middle strike price. It’s this visual representation that can provide insights into the risk and reward dynamics of the long call butterfly.
To recap, the call butterfly strategy offers an enticing way to capitalize on anticipated stability in stock prices, like with our Verizon example. The setup is straightforward and allows for significant potential profits against minimal risks. By analyzing historical price data, traders can gauge the viability of the strategy and make informed decisions. Always keep in mind that while the long butterfly can be a powerful tool, it requires careful planning and market analysis to execute successfully.
Pros and Cons of the Long Call Butterfly Strategy
Presented below is a straightforward table summarizing these points, helping you quickly grasp the benefits and drawbacks of implementing a long call butterfly in your trading strategy.
| Aspect | Pros | Cons |
| Risk | Limited exposure to losses, offers protection | May result in lower chances of gaining profits |
| Benefit | Possibility of significant returns, advantageous profit ratios | An increase in implied volatility can negatively impact the strategy |
| Other | Leverages time decay as an ally | The long butterfly is difficult to hedge |
Pros
- Capped loss risk: The long butterfly strategy limits potential losses through its structured spread, making it attractive to risk-averse traders.
- High profit ratio: The call fly offers significant potential gains that can outweigh potential losses.
- Favorable time decay: You benefit from the decay in option premiums over time, particularly if the asset price stays near the middle strike.
Cons
- Relatively low profit probability: The probability of achieving the maximum profit may not be high unless you predict the market movement with great precision.
- IV is against you: An increase in implied volatility can negatively affect your position, as it can inflate option premiums, complicating your exit strategy.
- Hedging is hard: Hedging long call butterfly positions is challenging because the strategy depends on hitting a specific price target for profitability. Since the strategy is structured with limited risk, additional hedging is often unnecessary. Long call options offer protection against significant movements in the underlying asset, ensuring risk is clearly defined at the start of the trade.
What More Should You Know About the Call Fly?
When trading a call butterfly, practical considerations often play a crucial role in its execution. One key aspect is the likelihood of closing the trade early, especially if the stock price enters the profit zone before expiration. Exiting the position ahead of time can help lock in gains and reduce exposure to changes in implied volatility (IV) or sudden market movements that might erode profitability.
Time decay, or theta, continues to benefit the strategy as long as the stock price remains near the middle strike. This gradual erosion of option premiums, particularly for the two short calls, enhances profitability as expiration approaches. However, it’s important to monitor the trade closely, as holding too long can sometimes expose the position to unfavorable shifts in IV or unexpected price moves.
Another practical point to consider is strike selection. Traders often use a call butterfly when the trade is set above the current stock price, while a put butterfly is preferred for trades below the current stock price. This approach aligns the strategy with expected price movement and ensures the setup fits the market outlook.
Adjustments and rolling can also play a role in managing the trade. If the market drifts away from the intended profit zone, adjusting the position by realigning the strikes or rolling the butterfly to a later expiration can help maintain the strategy’s viability. While these tactics can incur additional costs, they offer flexibility in adapting to changing market conditions.
By keeping these practical elements in mind—early exits, strike selection relative to the current price, and potential adjustments—you can optimize the performance of a call butterfly strategy and make more informed trading decisions. Always review your butterfly option graph and market conditions regularly to ensure the trade aligns with your expectations.
Before leaving you, consider that there actually is a way to trade a butterfly strategy with a directional bias. This strategy is called
broken-wing butterfly and its main appeal is the fact that it is a generally cheap trade with a potentially high profit ratio.
