Long Butterfly Spread Explained



The butterfly spread strategy is one options strategy which is suitable for intermediate traders. This uses both a bear and bull spread. When using this strategy it can be confusing because there are 3 strike prices which are involved. The diagram below should show how it is constructed.

long butterfly

Buy 1 In-The-Money (ITM) Call
Sell 2 At-The-Money (ATM) Calls
Buy 1 Out-of-The-Money (OTM) Call

Traders should only employ long butterfly spreads when they believe that the value of the stock will not rise or fall that much at the expiry date. This strategy is made by buying one lower in the money call, writing two at the money calls, and buying another higher out of the money call. To enter the trade you will take a net debit.

Potential Profit

Traders can make the maximum level of profit when the stock price is the same at the expiration date. It is possible to calculate the maximum profit fairly easily.

The maximum profit can be calculated by subtracting the strike price of the lower long call, premiums paid, and commissions away from the strike price of the short call. Or simply put:

Maximum Profit = Strike Price of Short call – Strike Price of long call – Premiums – Commission Payments

Potential Loss

The maximum amount of money a trader can lose using the long butterfly spread is limited to the premium charged, plus any commission you need to pay.

Maximum Loss = Total Premiums Paid + Commission Paid

The Maximum loss will occur when the underlying asset price is equal to the strike price of the lower strike long call. Or it can also happen if the price is equal to the strike price of the higher strike long call.

Breakeven

There are also two possible points where you would breakeven when using the butterfly spread. You can calculate both of these breakeven points as shown below:

Upper Breakeven Point = Strike Price of Higher Long Call Option – Premium

Lower Breakeven = Strike Price of Lower Long Call + Premium

Worked Example

In October, Apple stocks traded at $40. If you believe the stock prices will remain unchanged for the short duration, then you can execute a long call butterfly by buying a Nov 30 call for $1100, writing two NOV 40 calls for $400 each, and purchasing a NOV 50 call for $100. In order to execute these, the premium will be $400, the profit will be $600.

If stock traded below $30 or above $50 per stock at the date of expiry, then the maximum loss would have been made. If the stock was $30 then the options would be worthless. In either situation you would experience the maximum loss.

Commission

It’s worth noting that the example above doesn’t include any commission. You will need to pay your broker a certain percentage of commission every time you trade. As the butterfly spread uses a minimum of 4 contracts you might be paying a lot in commissions.

If you do decide to employ this strategy regularly then you might want to choose a broker which offers volume trading discounts. OptionsHouse for example only charge $0.15 per contract plus $8.95 per trade.

Conclusion

The Butterfly spread does look like a very complicated and difficult to manage trading strategy. However, once you have actually practiced this then it is possible to make money from it. You will find it easiest if you use a virtual trading platform to experiment and get to grips with the trading strategy, before you start.

This strategy isn’t really suitable for beginners because it is a bit complicated. It is better for intermediate traders which have more experience.




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