Long
Call Butterfly
Description
The
Long Call Butterfly is another rangebound strategy and is the opposite of a
Short Call Butterfly, which is a volatility strategy.
Long
butterflies are quite popular because they offer a good risk/reward ratio,
together with low cost. The long options at the outside strikes ensure that the
risk is capped on both sides, and this is a much more conservative strategy
than the Short Straddle.
The
Long Call Butterfly involves a low strike long call, two at-the-money short
calls, and an out-of-the-money long call. The resulting is profitable in the
event of rangebound 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.
Market
Opinion
Directional
neutral. You expect little movement in the price of the stock.
P/L
When
To Use
Use
this strategy when you expect the stock not to move very much, and can execute
a high-yielding trade at low cost for capital gain purposes.
Example
XXXX
is trading at $50 on May 12, 2011.
Buy
June 2011 45 strike call for $6.12.
Sell
two June 2011 50 strike calls at $3.07.
Buy
June 2011 55 strike call for $1.30.
Benefit
The
benefit is that, for little monetary outlay, you can profit from a rangebound
stock with capped risk.
Risk
vs. Reward
The
risk is the net debit of the options you bought and sold. The reward is the
difference between adjacent strikes minus the net debit.
Net
Upside
The
difference between strikes minus net debit.
Net
Downside
Net
debit paid.
Break
Even Point
Break
even up: higher strike minus net debit.
Break
even down: lower strike plus net debit.
Effect
Of Volatility
Low
volatility in the stock price is what you are looking for.
Effect
Of Time Decay
Positive
when the position is profitable and negative when the position is not
profitable. Entering the trade, the stock is profitable, so from then on the
effect of time decay is negative on the position.
Alternatives
Before Expiration
Unravel
the position if the stock moves outside of the stop loss areas below or above
the stock price.
You
can unravel it just before expiration.
Alternatives
After Expiration
Close
out the position by buying back the options you sold and selling the options
you bought.