A long call butterfly spread is an options trade with three parts, all of which are call options. The trader buys a call at a lower strike price and sells two calls at a higher price. Then the trader buys one more call at a higher price still. In this trade, the strike prices should be spaced at equal distances in price and all have the same expiration date. This is a complicated trade with a moderate profit potential and costs that can be high. Before executing this trade, you need to make certain that the risk to reward ratio is favorable.
When Should I Use a Butterfly Spread?
The time and place for a butterfly spread is in a tranquil market where you do not expect much if any volatility for the duration of the contracts. In this situation, a butterfly spread can provide a moderate profit with limited risk. You will use this strategy on a low-beta stock in a market with low volatility. You need to choose the right stock during the right circumstances for this trade and watch it carefully so that you can exit the trade with a desirable profit. And, if the stock becomes volatile, you need to have a clear exit strategy to avoid losing your profit.
Profit and Loss from a Long Call Butterfly Spread
Your top profit in this trade happens when, on the expiration date, the stock price equals the strike price of the two calls that you sold. The two call contracts that you sold will not be executed so you keep the premiums. The lower-price call that you purchased will gain you the difference between its strike price and the closing price of the stock. The top call that you purchased will expire worthless.
The worst loss occurs when the stock closes outside of the range of the calls that you purchased. The loss on the low side is what it cost you to set up the trade as none of the call contracts will be executed. When the stock closes on the high side, all calls will be executed at the same closing price and will cancel each other out. Thus, your cost will be that of setting up the trade.
Advantages and Disadvantages of a Butterfly Spread
The first advantage of a long call butterfly spread is that your risk is limited to the cost of setting up the trade which is the cost of the two calls that you purchase plus fees and commissions minus the premiums for the two calls that you sell. The other advantage is that you can make a small to moderate profit while controlling your risk. The disadvantages are that you miss out on potential gains if the stock moves a long way up or down and, at the same time experience a limited but predictable loss. Choosing the right stock in the right situation for this trade is important. This is a skill that you can learn when you are a member of Top Gun Options, get primary live trade briefs, and get to watch professional options traders in live trading.