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Long Butterfly
The long butterfly is a position that can be used when the trader believes the underlying stock will move sideways through expiration. This strategy combines a bullish vertical spread with a bearish vertical spread and has both limited risk and limited reward. We’ll use a call example to illustrate a long butterfly.
The long butterfly with calls is comprised of two long calls and two short calls. All options expire in the same month and the short calls are both ATM. One long call is ITM and one is OTM to create “wings” around the short ATM “body”. So the trade includes 1 ITM long, 2 ATM short calls and 1 OTM long call. This strategy is implemented for a net debit (the maximum risk) and performs best when the underlying remains in a narrow range through expiration. The maximum profit is limited to the difference between the strikes minus the net debit.
The call long butterfly combines a bull call spread (1 long ITM call + 1 short ATM call) and a bear call spread (1 short ATM call + 1 long OTM call) and as a result, is neutral. The upside breakeven is the highest strike minus the net debit and the downside breakeven is the lowest strike plus the net debit. This creates a profitability zone just within the two long strike prices. The risk is limited to both the downside and the upside (similar to a bear call spread and bull call spread, respectively) to the net debit paid to initiate the position. Profits are maximized when the underlying closes at the short call strike price-at this level the 2 short calls and 1 long OTM call expire worthless, while the long ITM is valued at the difference in strike price between the ATM call and the ITM call.
Table 1-1, provides trade details for a long butterfly on the Merrill Lynch Biotech HOLDRS fund (BBH) using calls. BBH has been trading sideways for almost four months by late August and the trader believes it will remain in a narrow trading range. Its current price is 178.35 and the trader reviews Oct call premiums to evaluate a long butterfly position.
| Price of BBH = 178.35 |
Call Strike Price
Oct 175
Oct 180
Oct 185 |
Market Price
7.80
4.60
2.70 |
Premium
+780
-9.20
+2.70
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Table 1-1: BBH Call Option Premiums (8/2006)
The trade is established by purchasing 1 Oct 175 call, selling 2 Oct 180 calls and buying 1 Oct 185 call for a net debit of $130 ((7.80 – (2 * 4.60) + 2.70) x 100 = 130). The maximum profit for this trade is the difference between the strike prices minus the net debit or $370 ((5 * 100) – 130 = 370). This will be realized if BBH closes at 180 at expiration. The upside breakeven is 183.70 (185 – 1.30 = 183.70) and the downside breakeven is 176.30 (175 + 1.30 = 176.30).
| BUTTERFLY STRATEGY REVIEW |
Strategy = Buy 1 ITM option, sell 2 ATM options and buy 1 OTM option
Market Opportunity = Look for a range-bound market that is expected to stay between the calculated breakeven points
Maximum Risk = Limited to the net debit paid
Maximum Profit = Limited to the difference between the strikes minus the net debit
Upside Breakeven = Higher strike price minus the net debit
Upside Breakeven = Lower strike price plus the net debit
Margin = Required. The amount is subject to your broker's discretion. |
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