Profiting From Low Volatility: Long Call Butterfly

The long call butterfly strategy allows traders to make a profit on low-volatility stocks

Nov 18, 2016 at 1:44 PM
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    While many option traders try to profit off increased volatility, there are also ways to profit off of decreased volatility. The long call butterfly strategy is just one way for option players to pad their pockets on an underlying equity that looks like it will remain relatively stagnant and stick close to a "magnet" strike.

    The long call butterfly is a good strategy choice for advanced traders who expect relatively little volatility from the underlying equity, and who have a specific target price in mind. A butterfly spread is generally a neutral trading strategy, although it is possible to make adjustments for option players who are particularly bullish or bearish, such as utilizing puts instead of calls, or adjusting the target strike-price.

    The butterfly spread is, essentially, a long call spread and a short call spread that meet in the middle. To initiate a long call butterfly, a trader would sell two at-the-money calls at the target strike, while also purchasing one in-the-money call and one out-of-the-money call; the bought calls should be equidistant to the sold call strike. The trade will be entered for a net debit, which also represents the maximum risk.

    The goal is for the equity to finish at the sold call strike by the time of expiration, allowing the investor to cash in on the lone in-the-money call, and retain the premium received from the two sold calls. So, the maximum reward is equal to the distance between the bought and sold strikes, minus the net debit. More broadly, there are two breakeven rails: the lower-strike call plus the net debit, and the higher-strike call minus the net debit.

    For an example, imagine a trader wants to open a long call butterfly trade on stock XYZ. XYZ is currently trading at $100, and the trader believes the stock will remain at or near the $100 mark over the short term. To profit off of this anticipated lack of volatility, the trader purchases an in-the-money December 90 call for $11, as well as an out-of-the-money December 110 call for 10 cents -- $11.10 for the pair. Then, the trader sells to open two at-the-money December 100 calls for $1 each, or $2 total. All in all, the trader establishes the long call butterfly for a net debit of $9.10, or $910 total ([$11.10 paid - $2 received] x 100 shares).

    To avoid a loss, the trader needs XYZ to stay between $99.10 (90 + $9.10) and $100.90 (110 - $9.10). Ideally, XYZ will finish exactly at $100, and the sold calls will expire worthless, allowing the trader to pocket the $200 in premium, as the purchased December 110 call expires worthless, and the December 90 call ends 10 points in the money. In this situation, the trader will profit $0.90 per spread ([100 - 90] - $9.10), or $90 total (x 100 shares).

    If XYZ, say, skyrockets to $150 in the options' lifetime, both bought calls will be in the money -- but so, too, will the pair of short calls. So, whether XYZ skyrockets above its top breakeven rail or plummets to zero, the maximum risk is limited to the initial net debit.

    While the long call butterfly is less risky than a short straddle or strangle, there is also a relatively slim margin for reward. This strategy is best utilized by traders who are experienced and confident they will be able to accurately predict the near-term price action of an equity.

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