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Call Butterfly - An Option Trading Strategy

Call butterfly an option trading strategy is also known as a long butterfly strategy. It is a multi -legged and neutral strategy. In this strategy, the risk is predefined, having limited profit potential. This strategy can be very beneficial when the volatility declines, time decays, and if there is a low movement in the underlying asset price.


In the call butterflies, there are four call options, all having the same expiry date. Of

these four, traders sell two short call options, buy one long call option above the short

strike price and buy the fourth long call option below the short strike price. A call

butterfly strategy is made up of selling the bull call debit spread and bear call credit

spread at the same strike price. The long call options contract is at an equal distance

to the short call options.


Traders can enter a call butterfly by paying a very small debit. Whatever amount is

paid by the traders initially is the highest risk. The highest profit potential is the gap

between the long strikes and short strikes minus the debit amount paid.


This strategy takes advantage of a decline in volatility, time decay factor or low or

no movement in the underlying asset price.


Call butterfly strategy from the market’s perspective:

Call butterflies strategy is a market-neutral strategy with no biases based on direction.

The strategy depends majorly on the low price movement of the underlying stock to

be profitable. In order to get maximum profit potential, the stock must close within the

strike price at the time of expiry. The highest amount a trader can lose is initially paid

while entering the strategy. Suppose, if at the time of expiry, the stock closes above the

higher strike price or below the lower strike price of long call options, then there will be

a maximum loss to the traders. Traders may enter the call butterfly strategy when he

expects that the stock prices will stay in between the ranges till they expire.


How can I set up a call butterfly strategy?

Call butterflies are short straddles with the long call option protection either above or

below the short strikes to limit the risk. The main objective of this strategy is that it must expire near the stock price at the time of expiry. This leads to the long call option, which is above the short strikes to expire out-of-the-money and the other long call option, which is below the short strikes to expire in-the-money.


Traders can get the highest profit by selling the in-the-money long call options and

buying the short call options again at a very small or no cost. The difference amount

the trader gets by selling in-the-money long call options, buying the short options

and deducting the initial debit paid will be the highest profit. On the other hand, if the

stock prices close either above or below the long call strike prices at the time of expiry,

it will result in a loss.


Suppose the stock prices close below the lower long call; then the options contract

will be out-of-the-money and expire worthlessly; the debit paid initially will turn into

a loss. If the stock price closes above the price of a higher long call, all four options

will expire in-the-money. If, in this case, the trader closes the entire position after its

expiry, then all four options would have to be executed and cancelled out, and the

initial debit paid will be lost.


Understanding the diagram of the call butterfly:

The diagram of the long call butterfly shows the highest risk and reward to the traders.

The highest loss to the traders is defined by combining the cost of all four options of

the underlying stock and can be realized if the stock closes above or below the long

options at the time of expiry. The profit in this strategy is limited to the width of the

spread between the lower long call options and two short call options contracts minus

the amount paid initially at the entry.


For example: let us assume that a call butterfly is cantered at Rs. 100. It has two

short call options at a strike price of Rs. 110 and two long call options at a strike price

of Rs. 90. Assuming the cost to enter the trade being Rs. 5, these Rs. 5 will be the

maximum loss to the trader. If the stock price closes at Rs.100 during the expiry, then

the two short-call options will expire worthlessly. The long call options of strike price

will be in-the-money by Rs. 10. If we deduct the initial debit paid to enter the trade -

Rs. 5, the strategy can earn the highest profit of Rs. 500.


If the stock price moves higher than Rs. 100 during expiry, but it is within the protective

wing of the long call option, then two short options will be in-the-money and will still

have some value left for profit. Traders need to repurchase in-the-money short options.

Whatever amount is involved in repurchasing the short options, selling the lower strike

long options contract with the remaining intrinsic value, and the initial debit paid to

enter the trade will decide the traders' net profit or a net loss.


If the stock price closes below Rs. 100 during the expiry, both the short and long call

options will expire worthlessly, and traders need to close the lower long calls. The credit

received by selling the call option minus the debit paid to enter will be the amount of

the trader's profit or loss.


The strategy can be said close at the break-even point if the underlying stock price is

either above or below the long call option by the amount equal to the premium paid.

In the example considered above - the downside break-even point will be Rs. 95

(lower strike Rs. 95 - Rs.5 net debit), and the upside break-even point will be Rs. 105

(higher strike price Rs. 110 - Rs.5 net debit).


Call Butterfly - An Option Trading Strategy

How can I enter a call butterfly options strategy?

A trader can enter the call butterfly with two sell-to-open (STO) call options at the same strike price and buy-to-open (BTO) two long call options, one above and the second below the short call options. All the call butterfly's four legs/ options contracts should expire on the same date. Traders do not need to sell a short call at at-the-money; instead, they are sold at the strike price, as the traders believe the stock will expire at the same price. The closer the stock price towards the short call options at the time of expiry, the more profit can be generated.


Focusing the call butterfly strategy below the current strike price will create a bearish

bias, as the stock price must decline to make the position profitable. Conversely,

focusing the call butterfly above the current strike price will create a bullish bias; in

this case, the stock price needs to rise to make the position profitable.


How can I exit the call butterfly strategy?

The call butterfly strategy can achieve maximum profit if the stock closes at exactly

the same price as the short strikes during the expiry. In this case, the short call option

will expire worthlessly, and the long call options that are in-the-money can be sold out.

The total width of the spread minus the initial debit paid results in the net profit to the

trader.


Suppose the stock prices close above the short call during expiry but still lie in the

protective wing of the long call; then, both short options will be in-the-money and

have some value left. The trader should repurchase an in-the-money short option.

The difference a trader gets from selling the lower call options, buying back the short

options, and the initial debit paid will result in either profit or loss of the trade.


If the stock price closes below the short options during expiry, then short and higher

long calls will expire worthlessly, and traders need to close the lower long options.

The credit amount received by selling the call options and deducting the initial debit

paid will give you the profit or loss on this trade.


Impact of the time decay on call butterfly strategy:

The time decay or theta factor works in favour of the call butterfly strategy. With each

passing day, the contract value decreases, which helps lower the value of two short

options. Generally, the stock faces limited movement, and theta will lose its value by

the time of expiry. Suppose the trader has sold or exited the long call before they expire. This decline in the theta will allow the trader to enter the trade again by purchasing the options at the low price then they were sold. At the same time, in-the-money long options will still have some intrinsic value left.


Impact of implied volatility on the call butterfly strategy:

Call butterfly strategy gets the benefit of the volatility decreases in the underlying

stock. Lower implied volatility will reduce the prices of options premiums. Generally,

at the beginning of the call butterfly, the volatility is high and reduces as the expiry

time approaches. Low implied volatility will reduce the value of the two short-call

options. Although it is challenging to predict volatility, knowing its impact on your

position might help you.


How can I adjust the call butterfly strategy?

Traders may adjust the call butterflies before the contract expires to extend the time

or to rebalance the short strikes in case they have shifted from the profit zone. Call

butterflies are the net debit strategies, so if traders try to adjust it, it will raise the

additional cost to the position, the risk will increase, the potential to profit will also

reduce, and the break-even points will be narrowed. As the call butterfly is made up

of two short contracts, the risk will be very high if they get executed before the expiry.


Traders must keep in mind some external factors, such as dividends while adjusting

or closing the butterfly position. If a trader wants to buy more time to let the situation

turn in their favour and make a profit, then the entire position can be closed and

reopened at some future date, either with the same strike price or new strike prices.


How can I roll the call butterfly strategy?

Call butterflies are needed to stay at or near a specific price at the time of expiry. If

the current position does not seem profitable, and traders wish to expand the trade

length, then the call butterflies can be closed and reopened at some future expiry date.

If you buy more time, there are chances that the options prices may rise so rolling will

add extra money to the short call options along with the risk. Suppose the stock price has moved away from the short call options, then closing the entire position and

entering again into a call butterfly with the price closer to the current stock price would be a wise choice. But, while doing so, if the debit paid exceeds the width spread, the position will no longer stay profitable, and the rolling will make no sense.


How to hedge a call butterfly?

It is difficult to hedge a long call position of the butterfly spread, as the strategy

depends on hitting the specific price to be profitable. As the strategy already has a

very limited risk structure, hedging might be unnecessary. Traders buy the long call

options to provide protection against the large moves of the underlying asset. Hence,

the risk factor in this strategy is well defined at the entrance of the trade.


Call broken wing butterfly:

You will find only slight changes in the structure of the broken wing butterfly and long

call options. Call broken wing is made by buying one in-the-money long call, selling

two out-of-the-money short call options, and buying one out-of-the-money long

call option above the price of the short call. Call broken-wing butterflies are centered

at the bull call spread, and the bear call spread has the same strike price. However,

one long call option, which is out-of-the-money and above the short strike price, is

not at an equal distance from the out-of-the-money long call below the short call's

strike price.


When buying long call options above the short calls options, the trader skipped one

strike price, which creates the "broken wing." Thus, this strategy gets a net credit while

entering the trade. Call broken wings butterflies are a little bullish and get positively

impacted by the time decay and volatility factor, just like the call butterfly.


If the stock price closes at the short strike price at the time of expiry, it would be the

best and ideal scenario. If the position is opened for credit, then any price movement

or decline in the price will not result in a profit.


The highest profit potential to a trader is the total credit received plus the width of the

bull call spread, and it can be realized only when the stock closes at the short call

options. The highest risk to the trader is the width spread below the short strike prices

minus the credit received. The break-even point is the one that is skipped plus the

credit received.


For example: If a stock has a current price of Rs. 98 and the trader expects that

there might be some change but a significant one. He may enter a call broken-wing

butterfly by buying a call of strike price Rs. 95, selling the two calls at Rs. 100 and buying a long call at Rs. 110. If, in this trade, the trader collects a credit of Rs. 1, the maximum profit can be Rs. 600 if the stock closes at Rs. 100 during expiry because the long calls will still have Rs. 5 intrinsic value plus the credit received initially. The short calls and out-of-the-money long calls will expire worthlessly. The highest risk is Rs. -400 if the stock price closes at or above Rs. 110. Suppose the stock closed at Rs. 110, then the

long call of Rs. 95 will still have the intrinsic value of Rs. 15, but the other two short

options will be Rs. 10 in-the-money. (Rs.15-Rs.20+Rs.1 =Rs. 4) The break-even point

here is Rs. 106 as the long call of Rs. 95 will have Rs. 11 intrinsic value, and each short

call would have Rs. 6 in-the-money and Rs. 1 credit received. Now, if the stock prices

fall below Rs. 95, options will expire worthlessly, and only Rs. 1 received as credit will

be the profit.


Call Butterfly - An Option Trading Strategy

So, this was all about the call butterfly. If you need clarification about this strategy,

we recommend you thoroughly study the call options and get information about the

butterfly strategy. If you are clear on both terms, you will be easily able to understand

the call butterfly strategy. If you have any further questions or need assistance, feel

free to contact our team at the below-given number.

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