Long Butterfly

Opinion: Neutral

Example:
Long 1 Oct 55 Put @ 2 3/16
Short 1 Oct 60 Call @ 5 1/8
Short 1 Oct 60 Put @ 4 1/4
Long 1 Oct 65 Call @ 3 1/8

Description: A Long Butterfly is a Short Straddle with a conservative twist! By purchasing two out-of-the-money options (one Put and one Call) the investor’s maximum risk exposure becomes definable.

Strategy Profile: The Long Butterfly is used by the investor who wants to profit from a forecast of a narrow trading range for XYZ, but is unwilling to accept the risk of unlimited losses that comes with the sale of a straddle.

When to use: As was the case with the Short Straddle, the investor should select this position only if XYZ is expected to trade within plus-or-minus 5% of $60 over the next 90 days. By buying the two options, the straddle’s risk has been capped, but the range of profitability has been reduced.

Profit & Loss Characteristics: Unlike the Short Straddle, this strategy has limited risk. It can be viewed as being short one 60-65 Call Vertical and short one 55-60 Put Vertical.

It’s maximum potential profit point is at the strike price ($60) at expiration, and it is equal to the spread’s initial credit. Most of profit develops in the last month because of rapid time decay.

Maximum loss in either direction is equal to strike price differential of one vertical spread (5) minus initial credit.

Break-even Points:
Upside: Strike price of straddle + net premium received.
Downside: Strike price of straddle – net premium received.

Time Decay: POSITIVE. If XYZ is near the strike price (60), profits from decay accelerate most rapidly in last few weeks before expiration.

Volatility: Because an increase in volatility has a larger impact on the two options making up the straddle than the two OTM options, an increase in volatility is a negative for the spread. The impact will depend to a large part on both the amount of time left until expiration and the price of XYZ relative to the strike price.

Because an increase in volatility can have a negative impact, it is important that the implied volatilities of XYZ’s option be near historic highs before an investor consider this spread.

Assignment Risk: This spread contains two written options. The investor must watch XYZ for possible assignment if XYZ is either significantly above or below the strike price as expiration approaches.

By monitoring the time premium of the in-the-money option, the investor can determine the likelihood of assignment.

Strategy Note: As with all spreads, commissions spent to both establish and close a spread with many “legs” can be costly. Therefore, some strategies should be viewed as possibly the result of one spread being adjusted with another.

For example, in this case, if an XYZ 60-65 Call Spread is sold and XYZ later declines, an XYZ 55-60 Put Spread could be sold as an adjustment. The net result would be a Long Butterfly Spread.