Explanation

A long call butterfly spread is a three-part strategy that involves selling and buying call option.For executing this option strategy, it involves buying one higher out-of-the-money (OTM)strike call, selling two middle at-the-money (ATM)strike calls, and buying one lower in-the-money(ITM)strike call. All call options should have the same expiry date, and the distance between the higher and lower strikes must be equal from the middle strike. The Long call butterfly option strategy is implemented for a net debit and both profit and loss are limited.

Risk:

Limited

The max downside of implementing a strategy is the cost of implementing it.

If the underlying price at expiry is lower than the lower strike price, all calls expire worthless and the cost of implementing the strategy is forfeited.

If the underlying price is greater than the higher strike price, all calls become ITM and the position has a net value of zero.

Reward:

Limited

Maximum profit is realized when the underlying security price at expiration closes close to the strike price of the middle short call. If the underlying price at expiry ends as per expectation of the trader, the middle put option will expire worthless, and traders will gain from the lower call. If the market moves out of strike range in either way, then it will start making loss. The loss generated will also be capped.

Max profit potential =Middle strike prices – lowest strike price – net cost of acquiring the position

Construction

Sell 2 ATM Call Options

Buy 1 ITM Call Option

But 1 OTM Call Option

PayoffChart

Example

Suppose that NIFTY is trading at 17780levels, trader sees low volatility in the market and expectsit to stay between a certain range. He implemented Long Call Butterfly option strategy.

The trader bought 17750 ITM call by paying premium of approx. 78.75, shorted 2 ATM calls and received premium of 49.5 each, and bought 17850 OTM call by paying premium of approx 28.65. Net investment for implementing strategy comes at Rs. 420. [{(49.5 * 2)-(78.75)-(28.65)}*50]

Scenario 1:

At expiryif Nifty closesat 17750, all option contract will expire worthless. The trader will loss the premium paid for implementing the strategy i.e. 420.

Scenario 2:

if at expiry market expire near the short call, the trader will stand to profit from long ITM call and all other contract will expire worthless. The profit will be equal to

Profit = premium received from shorting call + gain from the ITM call – prem paid for OTM call

2080 = ((17800 – 17750 – 78.75) + (49.5 *2) – 28.65) *50

Scenario 3:

At expiry, if market become volatile and start to rise and closes at 17850, the traders will make losses on his trades as all contracts will stand ITM.

Losses = Profit on ITM call – Loss on Short call + profit on long OTM call