By Ian Harvey
A butterfly option, otherwise known as a butterfly spread, is an option trading strategy. This strategy has limited risk, but also limited potential gain, and is based on a comparison between the expected future volatility, and the implied volatility of the underlying asset on which the options are based.
A butterfly spread combines a bull and bear spread and uses three strike prices. The lower two strike prices are used in the bull spread, and the higher strike price in the bear spread. Both puts and calls can be used.
Long Call Butterfly Option Spread
This type of option trading strategy is a conventional butterfly which provides neutral trades, but can be structured with more of a directional tilt by modifying the strike prices involved. The basic structure of a long butterfly is to sell the “body” and buy the “wings.”
The trade has a structure of 1 x 2 x 1. The body of the fly should be centered at whatever your target price is for the stock.
Therefore, in more detail, long butterfly spreads are entered when the investor thinks that the underlying stock will not rise or fall much by expiration. Using calls, the long butterfly can be constructed by buying one lower striking in-the-money call, writing two at-the-money calls and buying another higher striking out-of-the-money call. A resulting net debit is taken to enter the trade.
Maximum profit for the long butterfly spread is attained when the underlying stock price remains unchanged at expiration. At this price, only the lower striking call expires in the money. The formula for calculating maximum profit is given below:
• Max Profit = Strike Price of Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid
• Max Profit Achieved When Price of Underlying = Strike Price of Short Calls
Maximum loss for the long butterfly spread is limited to the initial debit taken to enter the trade plus commissions. The formula for calculating maximum loss is given below:
• Max Loss = Net Premium Paid + Commissions Paid
• Max Loss Occurs When Price of Underlying <= Strike Price of Lower Strike Long Call OR Price of Underlying >= Strike Price of Higher Strike Long Call
There are 2 break-even points for the butterfly spread position. The breakeven points can be calculated using the following formulae.
• Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid
• Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid