A long call butterfly is a neutral options strategy designed for investors who expect the price of an underlying asset to stay relatively close to a specific strike price by the time the options expire. It’s a limited risk, limited reward strategy that aims to profit from this lack of significant price movement.

Core Concept:

A long call butterfly is constructed by combining three call option contracts with the same expiration date but three different strike prices, all equidistant from each other. It involves:

1. Buying one call option with a lower strike price. This is the lower “wing” of the butterfly.
2. Selling two call options with a middle strike price. This is the “body” of the butterfly.
3. Buying one call option with a higher strike price. This is the upper “wing” of the butterfly.

The middle strike price (where you sell two calls) is the point of maximum potential profit, and it represents the price level you expect the underlying asset to be near at expiration. The lower and upper strikes act as the breakeven points and define the range of profitability.

Construction Example:

Suppose the underlying asset is trading at $50. A typical long call butterfly might be constructed with the following options, all with the same expiration date and a $5 width between strikes:

• Buy 1 Call Option with a $45 strike price.
• Sell 2 Call Options with a $50 strike price.
• Buy 1 Call Option with a $55 strike price.

Net Debit:

Establishing a long call butterfly typically results in a net debit, meaning you pay more to buy the two outer call options than you receive from selling the two middle call options. This net debit represents the maximum potential loss of the strategy (excluding brokerage commissions).

Profit and Loss Profile:

The profit and loss diagram of a long call butterfly resembles a peaked tent or an inverted “V” shape, with the peak at the middle strike price.

• Maximum Potential Profit: Occurs when the price of the underlying asset expires exactly at the middle strike price ($50 in our example). The maximum profit is calculated as the difference between the distance between the lower and middle strike (or the middle and upper strike) and the initial net debit. In our example, the distance is $5. So, the maximum profit would be $5 – net debit.

• Maximum Potential Loss: Limited to the initial net debit paid to establish the spread. This occurs if the price of the underlying asset expires at or below the lower strike price ($45) or at or above the higher strike price ($55). In these scenarios, all options expire worthless (if below $45) or offset each other with no additional profit beyond the initial cost (if above $55).

• Breakeven Points: There are typically two breakeven points for a long call butterfly:

  • Lower Breakeven: Lower strike price plus the net debit. In our example, if the net debit was $1.50, the lower breakeven would be $45 + $1.50 = $46.50.
  • Upper Breakeven: Upper strike price minus the net debit. In our example, the upper breakeven would be $55 – $1.50 = $53.50.

The position is profitable if the underlying asset price expires between these two breakeven points, with maximum profit at the middle strike.

Why Use a Long Call Butterfly?

• Expectation of Low Volatility/Minimal Price Movement Around a Specific Price: This strategy is ideal when an investor has a strong conviction that the underlying asset’s price will be very close to a particular strike price by expiration.
• Lower Capital Requirement Compared to a Short Straddle/Strangle: While also betting on low volatility, a long call butterfly has a defined and limited maximum loss, unlike short straddles or strangles which have potentially unlimited losses.
• Defined Risk and Reward: Both the maximum potential profit and the maximum potential loss are known at the time the trade is entered.

Key Considerations:

• Time Decay (Theta): Time decay generally works against a long call butterfly. As the expiration date approaches, the value of the purchased outer call options will decline, eroding the potential profit if the price doesn’t move precisely to the middle strike.
• Volatility (Vega): A decrease in implied volatility after the spread is established is generally beneficial for a long call butterfly, as it reduces the value of the sold middle call options more than the purchased outer call options. Conversely, an increase in implied volatility can be detrimental.
• Accuracy of Price Prediction: The strategy’s profitability is highly dependent on the underlying asset price expiring very close to the middle strike price. Even small deviations can significantly reduce or eliminate profits.
• Limited Profit Potential: The maximum profit is capped at the difference between the strikes minus the net debit.

Managing a Long Call Butterfly:

• Monitoring Price Movement: Closely tracking the underlying asset’s price relative to the middle strike price is crucial as expiration approaches.
• Taking Profits Early: If the price moves close to the middle strike price with significant time remaining, you might consider closing the position early to realize a portion of the maximum potential profit and avoid the risk of the price moving away before expiration.
• Rolling the Spread: If the price moves significantly away from the middle strike but there’s still time until expiration, you might consider “rolling” the spread by closing the existing positions and opening new ones with different strike prices or expiration dates, although this can be complex and may not always be advantageous.

Similar Strategies:

• Long Put Butterfly: Constructed with puts instead of calls, it has the same profit/loss profile but is used when a trader expects the price to stay near a specific strike price but wants to profit from a potential downward move.
• Iron Butterfly: A similar neutral strategy using both calls and puts, often established for a net credit and also profiting from low volatility around a central strike price.

In Conclusion:

The long call butterfly is a specialized options strategy for traders with a very specific and often short-term outlook on an underlying asset’s price. It offers a defined risk and reward scenario, with the maximum profit realized if the price lands precisely at the middle strike price at expiration. However, it is sensitive to time decay and requires accurate price prediction to be profitable. It’s a strategy best used when there is a high conviction of minimal price movement around a specific level.