Butterfly

The long butterfly is a three legged strategy. It is best for neutral outlook or when you are anticipating a very little change in the price of the stock during the life of the options. You can create a butterfly by using the call or the put options.

For example, the long call butterfly has three legs, consisting of four options: one long call, two short calls and long one call. All the options have the same expiration date. The middle strike is between the lower and higher strikes. When done properly, the gain is higher than the possible loss. However, both loss and profit potential are limited.

The total cost of the strategy is computed by multiplying the cost of the strategy with the shares they are for. The breakeven point will be at expiration if the price of the stock is equal to the values of one or two options. The second breakeven value is computed by removing the highest strike price from your net debit. The maximum potential for profit is computed by subtracting the net debit from the difference of the mid and lower strike prices. Your maximum risk is only limited to the cost of the strategy. If the price of the stock is equal to the mid strike prices, then you will have the maximum profit. You will have the maximum loss if the price of the stock becomes lower than the lowest strike price or above the highest strike price.

The butterfly can be simplified by breaking them in simpler parts. For example:

ABC trading @ $75.28
Buy 1 ABC 72 Call @ $6.10 $1,220.00 (wing)
Sell 2 ABC 75 Call @ $4.10 $1,640.00 (butterfly body)
Buy 1 ABC 78 Call @ $2.60 $520.00 (wing)
Net Debit from Trade $100.00

 

Here the total cost is $1 x the number of shares per option. This is equals to $100, excluding the commissions.

For the breakeven points, here is the formula:

First Break-even Point = Lowest Strike (72) + Net Debit (1) = 73

Second Break-even Point = Highest Strike (78) – Net Debit (1) = 77

The maximum profit is reached if the stock reaches the middle strike on expiration. Here is the formula:

Maximum Profit = Middle Strike – Lower StrikeĀ  – Net Debit

The maximum loss is computed as follows:

Maximum Loss = Net Debit

By looking at the bull call spread and the long call spread, you can see the spreads of the butterfly. This strategy is used by investors who anticipate narrow trading range for the stocks and are not willing to take unlimited risk of being short straddle. The strategy allows investors to have limited risks.

 

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