Options Strategy of the Day: The Long Call Butterfly

              

It really is impressive just how versatile options are as an investment vehicle. You can buy calls to simulate going long on a stock, or buy puts as an alternative to short selling. What's more, you can combine these seemingly innocuous building blocks into strategies designed to capitalize on a myriad of outcomes for the underlying security. One such strategy, which involves four separate option contracts, is the long call butterfly.

Butterfly spreads, in general, are neutral. However, you can skew the spread toward the bullish or bearish side by altering the strike prices or by utilizing puts instead of calls. The long call butterfly is typically executed by veteran option traders, due not only to the complexity of entering such a trade, but also the accuracy required in establishing the position. Ultimately, the long call butterfly strategy is designed to take advantage of time decay, with the trader typically betting on little-to-no movement from the underlying stock. As such, traders employing this options strategy tend to avoid equities with potential momentum-inducing catalysts, such as earnings reports or sales releases.

Constructing a Long Call Butterfly

The long call butterfly is essentially the combination of a short vertical call spread and a long vertical call spread, with the sold options meeting in the middle. More specifically, the position requires the simultaneous purchase of one out-of-the-money call and one in-the-money call, as well as the simultaneous sale of two at-the-money calls. All of the options should have the same expiration date, with the play established for a net debit.

As hinted at above, the objective of the long call butterfly is for the underlying security to finish exactly at the sold strike by options expiration. In this instance, three of the options will expire worthless, The objective is for the underlying shares to finish at the sold call strike at options expiration. When this occurs, both the sold calls will expire worthless, allowing the investor to capture the intrinsic value of the purchased lower-strike call, which would ideally outweigh the premium paid for the higher-strike call.

The maximum potential profit for the long call butterfly spread is limited, and is calculated by subtracting the lowest-strike call from the sold call strike, minus the initial net debit. This represents the most the trader can possibly gain on the position.

While the trader's profit is limited, so too is his loss. More specifically, the long call butterfly's maximum potential loss is limited to the premium paid to initiate the trade. In order to avoid a loss, however, the stock must remain pinned between two breakeven rails through options expiration. The lower breakeven level is equal to the lower-strike call plus the net debit, while the upper breakeven level is calculated by subtracting the net debit from the higher strike call.

Breaking Down an Example

The best way to fully appreciate the potential of this options strategy is to take a look at an example. Merck & Co. Inc. (MRK) has trended higher along support at its rising 10-week and 20-week moving averages for the past several months. However, the shares' uptrend has slowed significantly since they encountered resistance in the 37 region. With a lack of potential volatility-inducing events on the horizon, you decide that you want to exploit the shares' stagnation by employing a long call butterfly.

Since you believe that MRK will remain tethered to the $37 level for at least the next month, you choose to focus on the April 37 strike. To implement the strategy, you sell two at-the-money April 37 calls, which were last bid at $0.85. For the "wings" of your long call butterfly, you simultaneously buy the out-of-the-money April 38 call, which was last asked at $0.47, and the in-the-money April 36 call, which last crossed at $1.41.

Since the premium paid for the purchased options exceeds the premium received for the sold options, your long call butterfly is initiated for a net debit of $0.18 ([$0.85 * 2] – [ $0.47 + $1.41]). As such, you need MRK to remain between $36.18 per share ($36 + $0.18) and $37.82 per share ($38 - $0.18) through expiration to avoid incurring a loss on the play.

Potential Outcomes

There are several potential outcomes for this long call butterfly position. Under the best-case scenario, MRK closes at $37 per share when April options expire. In this situation, the sold April 37 calls and the purchased April 38 call expire worthless, while the purchased April 36 call finishes 1 point in the money. To exit the trade, all you will need to do is sell (to close) the April 36 call for $1.00. Subtracting the net debit of $0.18 paid at initiation, your profit comes in at $0.82, or $82 per contract, which represents the maximum gain on this long call butterfly.

However, what happens if MRK takes a turn for the worse and falls to $35 per share at expiration? In this case, all four of your options will expire worthless, leaving you with a loss of $0.18, or $18 per contract. This loss, which represents the net debit paid to enter the trade, is the maximum risk on a downside move by the underlying security.

On the other hand, if MRK were to rally to $39 per share by April options expiration, all four of your options will expire in the money. The purchased April 36 call with be worth $3, the two sold April 37 calls will be worth a combined $4, and the purchased April 38 call will be worth $1. To exit this trade, you would sell (to close) the April 36 and 38 calls for a total of $4, and buy (to close) the two April 36 calls for a total of $4. Once again, your total loss is limited to $0.18, or the net debit paid upon initiating the long call butterfly.

Wrapping Up

In conclusion, investors attempting this trade should target range-bound stocks with a lack of potential momentum-inducing catalysts (i.e. – earnings, drug-trial data, etc.). Furthermore, while the reduced risk of the long call butterfly can be quite appealing, the odds of accurately pinpointing a stock's short-term price action are quite slim. As such, only veteran option traders should attempt this trade.

Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com Web site provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options.