Long Butterfly Option Strategy

The long butterfly, also known as a butterfly spread, is an options trading strategy that involves using four options contracts with the same expiration date but three different strike prices. It is a limited profit, limited risk strategy designed to profit when the underlying asset’s price stays relatively stable near the middle strike price at expiration. It expresses a neutral view on the market, but with a defined range of profitability.

Construction

A long butterfly is created using the following options positions:

• Buy one call option with a lower strike price (K1).
• Sell two call options with a middle strike price (K2).
• Buy one call option with a higher strike price (K3).

Where K1 < K2 < K3, and K2 is the average of K1 and K3 (i.e., K2 = (K1 + K3) / 2). This ensures the butterfly is symmetric. The strike prices are often equidistant.

Profit & Loss Profile

The maximum profit potential of a long butterfly is achieved when the underlying asset’s price at expiration is equal to the middle strike price (K2). The maximum profit is equal to the difference between the middle strike price and the lower strike price (K2 – K1), minus the net premium paid to establish the position. The maximum risk (maximum loss) is limited to the net premium paid to establish the strategy. This occurs when the underlying asset’s price is either at or below the lower strike price (K1) or at or above the higher strike price (K3) at expiration.

The breakeven points are located at two price levels. One breakeven point is the lower strike price (K1) plus the net premium paid. The other breakeven point is the higher strike price (K3) minus the net premium paid.

Why Use a Long Butterfly?

Traders typically employ a long butterfly when they believe the underlying asset’s price will remain within a narrow range leading up to the expiration date. It’s a good choice if a trader has a strong conviction that price volatility will be low.

Advantages

• Limited Risk: The maximum loss is capped at the net premium paid.
• Defined Profit: Potential profit is also predefined.
• Lower Capital Requirement: It requires less capital than directly buying the underlying asset or other bullish/bearish strategies.

Disadvantages

• Limited Profit: The maximum profit is less than strategies with unlimited upside.
• Requires Accurate Prediction: The price must be close to the middle strike price to realize maximum profit.
• Commission Costs: Establishing the strategy requires placing four separate option trades, increasing commission costs.

Example

Suppose an investor believes that XYZ stock, currently trading at $50, will remain near that price in the coming month. They could establish a long butterfly by buying a call option with a $45 strike price, selling two call options with a $50 strike price, and buying a call option with a $55 strike price. The total cost (net premium) to establish the strategy is, say, $1. If the stock price is $50 at expiration, the investor achieves the maximum profit of $4 (5-1). If the stock price is below $45 or above $55, the investor loses the maximum of $1.

The long butterfly strategy can be a useful tool for option traders who have a neutral outlook and expect low volatility. However, it’s crucial to understand the risks and rewards before implementing this strategy.