10/27/2017 Long Butterfly Spread with Calls - Fidelity

Long butterfly spread with calls

THE OPTIONS INSTITUTE AT CBOE

Neutral

Goal
To pro it from neutral stock price action near the strike price of the short calls (center strike) with limited
risk.

Explanation
A long butter ly spread with calls is a three-part strategy
Example of long butterfly spread with
that is created by buying one call at a lower strike price,
calls
selling two calls with a higher strike price and buying one
call with an even higher strike price. All calls have the
same expiration date, and the strike prices are
equidistant. In the example above, one 95 Call is
purchased, two 100 Calls are sold and one 105 Call is
purchased. This strategy is established for a net debit, and
both the potential pro it and maximum risk are limited.
The maximum pro it is realized if the stock price is equal
to the strike price of the short calls (center strike) on the expiration date. The maximum risk is the net cost
of the strategy including commissions and is realized if the stock price is above the highest strike price or
below the lowest strike price at expiration.

This is an advanced strategy because the pro it potential is small in dollar terms and because costs are
high. Given that there are three strike prices, there are multiple commissions in addition to three bid-ask
spreads when opening the position and again when closing it. As a result, it is essential to open and close
the position at good prices. It is important to ensure the risk/reward ratio including commissions is
favorable or acceptable.

Maximum profit
The maximum pro it potential is equal to the difference between the lowest and middle strike prices less
the net cost of the position including commissions, and this pro it is realized if the stock price is equal to
the strike price of the short calls (center strike) at expiration.

In the example above, the difference between the lowest and middle strike prices is 5.00, and the net cost of
the strategy is 1.25, not including commissions. The maximum pro it, therefore, is 3.75 less commissions.

Maximum risk
The maximum risk is the net cost of the strategy including commissions, and there are two possible
outcomes in which a loss of this amount is realized. If the stock price is below the lowest strike price at
expiration, then all calls expire worthless and the full cost of the strategy including commissions is lost.
Also, if the stock price is above the highest strike price at expiration, then all calls are in the money and the
butter ly spread position has a net value of zero at expiration. As a result, the full cost of the position
including commissions is lost.

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Breakeven stock price at expiration

There are two breakeven points. The lower breakeven point is the stock price equal to the lowest strike
price plus the cost of the position including commissions. The upper breakeven point is the stock price
equal to the highest strike price minus the cost of the position.

Profit/Loss diagram and table: long butterfly spread with calls

Buy 1 XYZ 95 Call at 6.40 (6.40)
Sell 2 XYZ 100 Calls at 3.30 each 6.60
Buy 1 XYZ 105 Call at 1.45 (1.45)
Net Cost = (1.25)

Stock Price at Long 1 95 Call Short 2 100 Calls Long 1 105 Call Net Pro it/(Loss)
Expiration Pro it/(Loss) at Pro it/(Loss) at Pro it/(Loss) At at Expiration
Expiration Expiration Expiration

110 +8.60 (13.40) +3.55 (1.25)

105 +3.60 (3.40) (1.45) (1.25)

100 (1.40) +6.60 (1.45) +3.75

95 (6.40) +6.60 (1.45) (1.25)

90 (6.40) +6.60 (1.45) (1.25)

Appropriate market forecast

A long butter ly spread with calls realizes its maximum pro it if the stock price equals the center strike
price on the expiration date. The forecast, therefore, can either be neutral or modestly bullish,
depending on the relationship of the stock price to the center strike price when the position is established.

If the stock price is at or near the center strike price when the position is established, then the forecast
must be for unchanged, or neutral, price action.

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If the stock price is below the center strike price when the position is established, then the forecast must be
for the stock price to rise to the center strike price at expiration (modestly bullish).

While one can imagine a scenario in which the stock price is above the center strike price and a long
butter ly spread with calls would pro it from bearish stock price action, it is most likely that another
strategy would be a more pro itable choice for a bearish forecast.

Strategy discussion
A long butter ly spread with calls is the strategy of choice when the forecast is for stock price action near
the center strike price of the spread, because long butter ly spreads pro it from time decay. However, unlike
a short straddle or short strangle, the potential risk of a long butter ly spread is limited. The tradeoff is that
a long butter ly spread has a much lower pro it potential in dollar terms than a comparable short straddle
or short strangle. Also, the commissions for a butter ly spread are higher than for a straddle or strangle.

Long butter ly spreads are sensitive to changes in volatility (see Impact of Change in Volatility). The net
price of a butter ly spread falls when volatility rises and rises when volatility falls. Consequently some
traders buy butter ly spreads when they forecast that volatility will fall. Since the volatility in option prices
tends to fall sharply after earnings reports, some traders will buy a butter ly spread immediately before the
report. The potential pro it is high in percentage terms and risk is limited to the cost of the position
including commissions. Success of this approach to buying butter ly spreads requires that the stock price
stay between the lower and upper strikes price of the butter ly. If the stock price rises or falls too much,
then a loss will be incurred.

If volatility is constant, long butter ly spreads with calls do not rise in value and, therefore, do not show
much of a pro it, until it is very close to expiration and the stock price is close to the center strike price. In
contrast, short straddles and short strangles begin to show at least some pro it early in the expiration cycle
as long as the stock price does not move out of the pro it range.

Furthermore, while the potential pro it of a long butter ly spread is a high percentage pro it on the capital
at risk, the typical dollar cost of one butter ly spread is low. As a result, it is often necessary to trade a
large number of butter ly spreads if the goal is to earn a pro it in dollars equal to the hoped-for dollar pro it
from a short straddle or strangle. Also, one should not forget that the risk of a long butter ly spread is still
100% of the cost of the position. Therefore, if the stock price begins to fall below the lowest strike price or
to rise above the highest strike price, a trader must be ready to close out the position before a large
percentage loss is incurred.

Patience and trading discipline are required when trading long butter ly spreads. Patience is required
because this strategy pro its from time decay, and stock price action can be unsettling as it rises and falls
around the center strike price as expiration approaches. Trading discipline is required, because, as
expiration approaches, small changes in stock price can have a high percentage impact on the price of a
butter ly spread. Traders must, therefore, be disciplined in taking partial pro its if possible and also in
taking small losses before the losses become big.

Impact of stock price change

Delta estimates how much a position will change in price as the stock price changes. Long calls have
positive deltas, and short calls have negative deltas.

Regardless of time to expiration and regardless of stock price, the net delta of a long butter ly spread
remains close to zero until one or two days before expiration. If the stock price is below the lowest strike
price in a long butter ly spread with calls, then the net delta is slightly positive. If the stock price is above
the highest strike price, then the net delta is slightly negative. Overall, a long butter ly spread with calls

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does not pro it from stock price change; it pro its from time decay as long as the stock price is between the
highest and lowest strikes.

Impact of change in volatility

Volatility is a measure of how much a stock price luctuates in percentage terms, and volatility is a factor in
option prices. As volatility rises, option prices tend to rise if other factors such as stock price and time to
expiration remain constant. Long options, therefore, rise in price and make money when volatility rises,
and short options rise in price and lose money when volatility rises. When volatility falls, the opposite
happens; long options lose money and short options make money. Vega is a measure of how much
changing volatility affects the net price of a position.

Long butter ly spreads with calls have a negative vega. This means that the price of a long butter ly spread
falls when volatility rises (and the spread loses money). When volatility falls, the price of a long butter ly
spread rises (and the spread makes money). Long butter ly spreads, therefore, should be purchased when
volatility is high and forecast to decline.

Impact of time
The time value portion of an options total price decreases as expiration approaches. This is known as time
erosion. Theta is a measure of how much time erosion affects the net price of a position. Long option
positions have negative theta, which means they lose money from time erosion, if other factors remain
constant; and short options have positive theta, which means they make money from time erosion.

A long butter ly spread with calls has a net positive theta as long as the stock price is in a range between
the lowest and highest strike prices. If the stock price moves out of this range, however, the theta becomes
negative as expiration approaches.

Risk of early assignment

Stock options in the United States can be exercised on any business day, and holders of short stock option
positions have no control over when they will be required to ful ill the obligation. Therefore, the risk of
early assignment is a real risk that must be considered when entering into positions involving short
options.

While the long calls in a long butter ly spread have no risk of early assignment, the short calls do have such
risk. Early assignment of stock options is generally related to dividends. Short calls that are assigned early
are generally assigned on the day before the ex-dividend date. In-the-money calls whose time value is less
than the dividend have a high likelihood of being assigned.

If one short call is assigned, then 100 shares of stock are sold short and the long calls (lowest and highest
strike prices) remain open. If a short stock position is not wanted, it can be closed in one of two ways. First,
100 shares can be purchased in the marketplace. Second, the short 100-share position can be closed by
exercising the lowest-strike long call. Remember, however, that exercising a long call will forfeit the time
value of that call. Therefore, it is generally preferable to buy shares to close the short stock position and
then sell the long call. This two-part action recovers the time value of the long call. One caveat is
commissions. Buying shares to cover the short stock position and then selling the long call is only
advantageous if the commissions are less than the time value of the long call.

If both of the short calls are assigned, then 200 shares of stock are sold short and the long calls (lowest and
highest strike prices) remain open. Again, if a short stock position is not wanted, it can be closed in one of
two ways. Either 200 shares can be purchased in the market place, or both long calls can be exercised.
However, as discussed above, since exercising a long call forfeits the time value, it is generally preferable to
buy shares to close the short stock position and then sell the long calls. The caveat, as mentioned above, is
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commissions. Buying shares to cover the short stock position and then selling the long calls is only
advantageous if the commissions are less than the time value of the long calls.

Note, however, that whichever method is used, buying stock and sell the long call or exercising the long call,
the date of the stock purchase will be one day later than the date of the short sale. This difference will
result in additional fees, including interest charges and commissions. Assignment of a short option might
also trigger a margin call if there is not suf icient account equity to support the stock position created.

Potential position created at expiration

The position at expiration of a long butter ly spread with calls depends on the relationship of the stock
price to the strike prices of the spread. If the stock price is below the lowest strike price, then all calls
expire worthless, and no position is created.

If the stock price is above the lowest strike and at or below the center strike, then the lowest strike long call
is exercised. The result is that 100 shares of stock are purchased and a stock position of long 100 shares is
created.

If the stock price is above the center strike and at or below the highest strike, then the lowest-strike long
call is exercised and the two middle-strike short calls are assigned. The result is that 100 shares are
purchased and 200 shares are sold. The net result is a short position of 100 shares.

If the stock price is above the highest strike, then both long calls (lowest and highest strikes) are exercised
and the two short calls (middle strike) are assigned. The result is that 200 shares are purchased and 200
shares are sold. The net result is no position, although several stock buy and sell commissions have been
incurred.

Other considerations
A long butter ly spread with calls can also be described as the combination of a bull call spread and a bear
call spread. The bull call spread is the long lowest-strike call combined with one of the short center-strike
calls, and the bear call spread is the other short center-strike call combined with the long highest-strike
call.

The term butter ly in the strategy name is thought to have originated from the pro it-loss diagram. The
peak in the middle of the diagram of a long butter ly spread looks vaguely like a the body of a butter ly, and
the horizontal lines stretching out above the highest strike and below the lowest strike look vaguely like the
wings of a butter ly.

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Related Strategies
Short butter ly spread with calls
A short butter ly spread with calls is a three-part strategy that is created by selling one call at a lower strike
price, buying two calls with a higher strike price and selling one call with an even higher strike price.

Long butter ly spread with puts

A long butter ly spread with puts is a three-part strategy that is created by buying one put at a higher strike
price, selling two puts with a lower strike price and buying one put with an even lower strike price.

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Article copyright 2013 by Chicago Board Options Exchange, Inc (CBOE). Reprinted with permission from CBOE. The statements and
opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any
statements or data.

Options trading entails signi icant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk.
Before trading options, please read Characteristics and Risks of Standardized Options . Supporting documentation for any claims, if
applicable, will be furnished upon request.

Charts, screenshots, company stock symbols and examples contained in this module are for illustrative purposes only.

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