Execute A Long Call Butterfly Spread : Profit From Range Bound Markets

Introduction To Long Call Butterfly Spread Option Strategy

Executing Long Call Butterfly Spread Strategy

The long call butterfly spread is classified as an options strategy that capitalises on low volatility. It  is part of a family of spreads that serves to limit both risk and profit.  The set up of a long call butterfly spread can be created with call options on the same underlying security, with different strike prices.

Net debit

Executing a long call butterfly spread will result in a net debit, that is, net premiums paid to initiate the trade.

Steps

Step 1 :Perform economic, fundamental and technical analysis
Step 2 : Outlook : Range bound or stagnant
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss and maximum risk
Step 7 : Calculate Loss
Step 8 : Limited potential profit
Step 9 : Calculate Profit
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a butterfly spread
Step 12 : Exit Trade
Step 13 : Record Trade In Diary
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Step 1 : Perform economic, fundamental and technical analysis

To gauge the direction of the markets and the  underlying security, it is essential to perform economic analysis, fundamental analysis and technical analysis. In terms of economic analysis, make sure that there are no pending announcements that will cause markets to be volatile. With regards to fundamental analysis, ascertain that the valuation  of the company is not going to change much from current levels. On a technical basis, look for charts that trade in ranges.  Some chart patterns option traders should look out for is:

As a suggestion, the trader may opt to use the condor options strategy as the range of profits may be wider.This is also dependent on how the trader structures his trade. In the case of the long call butterfly spread, the range of profits reaches a maximum at only 1 price point whereas the maximum profit can be attained with the condor options strategy over a range of price points.

Read : Basic Economic Analysis, Basic fundamental Analysis and  Introduction to technical analysis

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Step 2 :Outlook : Range bound or stagnant

A trader that uses a long call butterfly spread is predicting there is little or no movement of the price of the underlying security. Hence, range bound markets are most suited to the strategy as a maximum profit can be experienced within the upside and downside breakeven point.

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Step 3 :Study the option chain

After coming to a conclusion on the outlook of the markets and  the underlying security, examine the option chain and look for option contracts that are suitable to the construction of a long call butterfly spread. Structure the long call butterfly spread in such a way that there is a minimum net debit. There are three strike prices which are used in the creation of a long call butterfly spread.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

The breakeven points are prices of the underlying security where there is neither profit nor loss. With regards to the butterfly spread, there are two breakeven price points. There is an upside breakeven point and a downside breakeven point.

The upside breakeven price point is:

Exercise price of higher strike bought call – net debit(net premiums paid)

The downside breakeven price point is:

Exercise price of lower strike bought call +net  debit(net premiums paid)

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Step 5: Understand Your Profit Zones

Executing Long Call Butterfly Spread Strategy

 

After calculating the breakeven points, the trader can have a better understanding of the profit zones. A profit is realisable if the price of the underlying security trades between the breakeven points.

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Step 6 : Limited loss and maximum risk

The butterfly spread has a limited loss profile. The maximum loss is limited to the net premiums paid to initiate the spread. The net premiums paid are a debit to the trading account. The maximum loss occurs when the strike price of the lower strike long call is greater or equal to the trading price of the underlying security. a maximum loss could also occur of the strike price of the higher strike long call is less than or equal to the price of the underlying security.

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Step 7 : Calculate Loss

The maximum loss can be calculated as :

Net Debit(net premiums paid) + brokerage fees

The brokerage commission play a part in widening a loss. Hence, it is important to look for a broker whose commissions are low. If you are a frequent trader, make sure that you do that.

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Step 8 : Limited potential profit

A long call butterfly spread is a limited profit strategy. The trader predicts that the underlying security price is stagnant or moves very little within a tight range. When that happens, a trader can realise a profit.

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Step 9 : Calculate Profit

The maximum profit can be calculated as:

Exercise price of the shorted calls – Exercise price of the lower strike long call – net debit paid – brokerage fees

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Step 10 : Calculate Risk & Reward Ratio

By calculating potential maximum profit and loss, one is able to calculate the risk reward ratio. Do so to make sure that the risk reward ratio is acceptable, relative to the other trades you have done.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing a butterfly spread

The ratio of bought in the money calls to short at the money calls to bought out of the money calls is 1 : 2 : 1. A long call butterfly spread is created with call options.

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Step 12 : Exit Trade

Consider exiting the position when there is a reasonable profit and there is less than 30 days to expiration. If the price of the underlying security is trading below the downside breakeven, let the  options expire worthless and take a loss. If the price of the underlying security is trading above the upside breakeven, close the position as there is a high prospect of assignment.

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Step 13 : Record Trade In Diary

After the trade has been exited, profits and losses will have to be recorded in the trading diary. Analyse  your mistakes and make sure to avoid them at all costs in the future. The purpose of recording your trades in a diary is to refine your trade process over time.

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Example Of A Long Call Butterfly Spread

The price of TTT Corp is trading at $50. An options trader initiates a a long call butterfly spread by buying a December 40 call at a price of $1200, shorting 2 December 50 calls at a price of $250 each and buying a December 60 call at a price of $100.

The net debit to the trade is:

$1200  – $250 x 2  + $100 = $800

The net debit is also the net premiums paid for the butterfly spread.

If the price of TTT trades at $50 on the expiration date of the options, the December 50 and December 60 calls will expire worthless. Hence the gain on the December 50 calls is:

$250 x 2 = $500

The loss on the December 60 calls is:

$100

The intrinsic value of the December 40 call at expiration would be:

$1000

The loss on the December 40 call is thus:

$1200 – $1000 = $200

The total gain is thus:

$500 – $100 – $200 = $200

If the price of TTT trades at $20 on expiration of the options, the calls will expire worthless and the trader’s maximum loss is $800.

If the price of TTT trades at $80 on expiration of the options, the December 40 calls will have an intrinsic value of $4000. The gain on the December 40 call is:

$4000 – $1200 = $2800

The loss on the 2 December 50 calls is:

2 x $3000(intrinsic value) – $500 = $5500

The gain on the December 60 call is:

$2000 – $100 = $1900

The net loss is thus:

$5500 – $1900 – $2800 = $800

As you can see the maximum loss is again $800.

Hence, the long call butterfly spread has a maximum loss that is equal to the net debit of the trade.

Read : Execute A Long put butterfly : profit from low volatility conditions

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