Long Butterfly
Risk: low
Reward: low
General Description
Entering a long butterfly entails buying 1 call at a lower strike price, selling 2 calls at a middle strike price, and buying 1 call at a higher strike price. The middle strike is midway between the higher and lower strikes. Essentially the long butterfly is a combination of the bull call spread and bear call spread.
The Thinking
You are not bullish or bearish and you feel fairly certain the stock will not move much from its current position. Because you think the stock will trade sideways you sell calls. If the stock doesn't move the calls would deteriorate in price and you would make money. But at this point you are naked and have huge exposure to the upside, so you buy the calls at the lower and higher strike prices. This limits your reward because you are locking in your max profit at a lower price, but it also limits your risk in case the stock rallies. This strategy is not recommended by those who trade small position sizes because commissions will kill you. This strategy is best used by those looking to make small amount of money multiplied by a large position size.
Example
Let's say CAT is trading @ 65, and you buy (1) 60 call for 5.5 and (1) 70 call for 0.50, and you sell (2) 65 calls for 2.25 for a net debit of 1.5..
Max profit occurs when the stock closes at 65 – the short calls expire worthless; you keep the entire premium; the long 60 call gets sold for a for a small profit; and the long 70 call expires worthless. Your max loss is locked in place at the onset and will occur if the stock closes below 60 (all calls expire worthless) or above 70 (long and short calls will all cancel each other out).
The image below summarizes the trade with a P/L Diagram. |
