Who Should Consider a Long Call Butterfly Spread?
- An investor who is anticipating minimal movement on a index within a certain period of time.
A Long Call Butterfly Spread is the combination of two other popular option strategies. It is a Bull Call Spread and a Bear Call Spread. The Butterfly is often considered a neutral strategy which allows an investor the opportunity to profit from a somewhat narrow range in the underlying index during a specific period of time.
Buying index calls as part of this strategy gives the buyer the right, but not the obligation, to buy upon exercise the value of the underlying index at the stated exercise (strike) price before the option expires. American-style index options may be exercised at any time before the contracts expire. European-style index options may be exercised only within a specific period of time, generally on the last business day before expiration. However, any long index option may be sold in the marketplace on or before its last trading day if it has market value. All index options are cash settled. For contract specifications for various index option classes, please visit the Index Options Product Specifications.
The seller of an index call option has the obligation to sell the value of the underlying index at the stated exercise price if assigned an exercise notice before the option expires. If assigned on an in-the-money contract, the index call seller will pay the cash settlement amount (the difference between the call’s strike price and the exercise settlement value of the underlying index) in cash to a buyer who has exercised a similar contract. Now that you are aware of the rights and obligations of index call sellers and buyers, you should also know that this neutral strategy is established with the purchase and sale of the same amount of calls.
The profit potential for a Long Call Butterfly Spread is limited to the difference in the strike prices of the long call spread less the net debit paid for the spread. The maximum profit is achieved at expiration when the value of the index equals the strike price of the short calls. The financial risk is limited to the net debit paid to establish the spread. The break-even points are the lower strike plus the net debit paid and the highest strike less the net debit paid.
After the Butterfly is established, an increase in implied volatility will have a greater negative financial impact on the options you sold than the positive financial impact on the options you bought. A decrease in implied volatility will have a more favorable financial effect on the short calls than the negative financial impact on the calls you bought. Keep in mind, volatility up, call premiums up. Volatility down, call premiums down. It is also very important to pay close attention to an increase in implied volatility which may imply an increase in movement either up or down in the index, which you don’t want with a neutral strategy.
Time decay will be favorable to this spread because the at-the-money calls you sold will have more time premium than the options you bought.