What is the Call Butterfly option strategy?

Of the many different option trading strategies that exists in the market, the call butterfly option strategy is a very interesting alternative for those traders that wants to focus on buying options and have a good technical analysis in their hands.

In this article, we are going to be focusing on what is the call butterfly option strategy, we will be learning how to take the best from it and how to use the time decay in our favor.

What is the call butterfly option strategy?

The call butterfly is an option strategy that can be used either as a directional or a neutral strategy, but it works better used as a directional trade.

The strategy is formed by buying and selling four Out of the Money call options. The calls that we sell are usually taken with the same strike price, while the strike price of the calls that are bought will be taken at the same distance from the sold ones.

As this can sound a little confusing, let us take a look at an example of the long call butterfly option strategy.

An example of the long call butterfly option strategy

Let us suppose that we want to trade a long call butterfly option strategy on a stock whose underlying price is $100. We have made our analysis and we believe that the stock is going to rise in the next 10 days up until it reaches $110.

So, we will open a long call butterfly option strategy. First, we will sell two call options with a strike price of $110, and then, we will buy one call option with a strike price of $114 and another one with a strike price of $106.

The result of this trade can be seen in the following image of our option strategy builder

As it can be seen, for opening one single long call butterfly, we will need to pay $31 without commissions. However, be aware that the commissions on a trade like this are high, because we are trading with four options at the same time.

We could expect commissions rounding about $4 or $5 in total for the entry alone. In any case, to better understand how this strategy works, let us take a look at the diagram.

Understanding the long call butterfly option strategy payoff diagram

In the following image, we can see the expected payoff diagram.

As it can be seen, the maximum profit that we could take on this trade is $369 if the underlying price is exactly at $110 at the expiration date. However, we should keep in mind that this is not very probable.

As for the maximum loss possible, the long call butterfly option strategy risk is set once we enter the trade by the premium we paid to open it.

So, yes, this trade has a very high risk/reward ratio and it is arguably better than many other buying strategies out there. But, as you can see on the previous graph, the value of the butterfly will increase as the time passes.

Let us now analyze the effects of volatility and time decay in this strategy.

Effects of time decay and volatility on the long call butterfly option strategy

First, let us focus on the effects of the volatility on the strategy.

Just like many other strategies, an increment on the volatility will damage the results of the diagram. While, at the other hand, if the volatility is reduced while we are in the trade, the payoff diagram will be better.

Volatility increased by 30$

Volatility reduced by 30%

Now, let us focus on the effects of time decay.

Time decay on the long call butterfly spread

In the graph, we can easily see how time decay is the key in the long call butterfly option strategy. In the following image, it is possible to see how the strategy will take and extreme advantage when it approaches to the expiration date.

However, in the case that the underlying price begins to rise with strength, we will not get almost any profit.

The main advantage and disadvantage of the long call butterfly option strategy is both the dependency on the time decay.

Some tips to improve the long call butterfly spread

Now, if we wanted to increase the probability of obtaining a better profits with the call butterfly, the only thing we need to do is to take the strike price of the calls that we bought with a farther distance from the short calls.

For example, if we picked the $117 and the $103 strike prices for the calls, while it is true that we will have to pay more for opening the trade, the area of profitability will be increased and the strategy will not rely so much on time decay.

In this case, we are paying $98 to enter the long call butterfly spread

Example of the short call butterfly option strategy

While other strategies such as the strangle has a long and a short version, it is not the case for the call butterfly spread.

Not that the short call butterfly option strategy does not exists. What we mean is that the short version makes no sense to be used because it has no point.

We are going to reverse the trade that we saw in the previous example to help you understand what we mean.

As it can be seen, there is no point in obtaining a profit of $31 while we are facing a potential risk of losing $469.

That is the reason why the short call butterfly option strategy is pointless in trading options.

When to use the call butterfly option strategy?

We should use this strategy in those situations in which we believe that the underlying price is going to rise but we expect that it will take some time to reach a certain price.

Remember that the long call butterfly spread will take advantage of time decay, so if we are right on direction and time, we could make a lot of money because of the incredibly high risk/reward ratio the strategy provide us.

Where to get the long call butterfly strategy calculator?

Would you like to get the long call butterfly strategy calculator that we have been using in this article? No problem!

Our advanced option strategy builder excel will allow you not only to create the long butterfly spread, but any other strategy that you want!