A call butterfly, also known as a long butterfly, is a multi-leg, risk-defined, neutral strategy with limited profit potential. The strategy looks to take advantage of a drop in volatility, time decay, and little or no movement from the underlying asset.
Call butterflies have four call option components with the same expiration date: two short calls sold at the same strike price, one long call purchased above the short strikes, and one long call purchased below the short strikes. A call butterfly is a combination of a bull call debit spread and a bear call credit spread sold at the same strike price. The long call options are equidistant from the short call options.
Entering a call butterfly will typically result in paying a small debit. The initial amount paid to enter the trade is the maximum defined risk. The profit potential is limited to the difference between the long and short strikes minus the debit paid.
The strategy looks to take advantage of a drop in volatility, time decay, and little or no movement from the underlying asset.
Call Butterfly Outlook
Call butterflies are market neutral and have no directional bias. Call butterflies depend on minimal movement from the underlying stock to be profitable. For the position to reach maximum profit potential, the underlying stock price would need to close at the inside short strike prices at expiration. The initial cost to enter the position is the most an investor can lose. If the stock price closes above the higher strike long call or below the lower strike long call, the maximum loss will be realized. A call butterfly is used when the underlying asset is expected to stay within a small range before expiration.
Call Butterfly Setup
Call butterflies are essentially a short straddle with long call option protection purchased above and below the short strikes to limit risk. The goal is for the stock price to close at the centered short strikes at expiration. This results in one long call option (above the short strikes) expiring out-of-the-money and one long call option (below the short strikes) expiring in-the-money.
The maximum profit is achieved by selling the in-the-money long call option and buying back the short call options at little or no cost. The difference between selling the in-the-money long call option and purchasing the short options, minus the original debit paid, is the realized profit. The maximum loss would occur if the stock price closed above the higher strike long call or below the lower strike long call at expiration.
If the stock price closes below the lower long call, all options would be out-of-the-money and expire worthless, and the original debit paid would be lost. If the stock price closes above the higher long call, all options would expire in-the-money. If the positions were not closed before expiration, all four options would be exercised and cancel out, and the original debit would be lost.
Call Butterfly Payoff Diagram
The payoff diagram of a long call butterfly defines the maximum risk and reward. The maximum loss on the trade is defined at entry by the combined cost of the four call options and is realized if the underlying stock price closes above or below the long options at expiration. The profit potential is limited to the width of the spread between the lower long call option and the two short call options, minus the debit paid to enter the position.
For example, assume a call butterfly is centered at $100 with two short call options, and long call options are purchased at $110 and $90. If the cost to enter the position is $5.00, that is the maximum loss that can be realized. If the stock is at $100 at expiration, the two short call options would expire worthless, and the $90 long call option would be in-the-money by $10.00. After subtracting the original debit of $5.00, the strategy would experience the maximum profit potential of $500.
If the stock price is above $100 at expiration but still within the protective “wing” of the long call, both of the short options would be in-the-money and still have value. The in-the-money short options would need to be repurchased. The difference between buying back the short options, selling the lower strike long option with value remaining, and the original debit paid would equal the trade’s profit or loss.
If the stock price is below $100 at expiration, the short calls and upper long call will expire worthless, and the lower long call would need to be closed. The credit received for selling the call option, minus the debit originally paid, would equal the trade’s profit or loss.
The strategy will break even at expiration if the underlying stock price is above or below the long options by the amount of the premium paid. In the above example, the downside break-even would be $95 ($90 lower strike + $5.00 net debit), and the upside break-even would be $105 ($110 higher strike price - $5.00 net debit).
Entering a Call Butterfly
A call butterfly is created by selling-to-open (STO) two call options at the same strike price and buying-to-open (BTO) long call options above and below the short call options. All four legs of a call butterfly have the same expiration date. The short calls do not need to be sold at the money. However, the short calls are sold at a strike price the investor believes the stock will be at expiration. The closer the stock price is to the short call contracts at expiration, the more profit will be realized.
Centering a call butterfly below the current strike price creates a bearish bias because the stock price will need to decline for the position to reach its max profit potential. Conversely, centering a call butterfly above the current strike price creates a bullish bias. The stock price would need to increase for the position to reach its maximum profit potential.
Exiting a Call Butterfly
A call butterfly will experience its maximum profit potential if the stock price is exactly the same as the short strike options at expiration. In this scenario, the short call options will expire worthless, and the long call option that is in-the-money may be sold. The width of the spread, minus the debit paid, will result in a profit.
If the stock price is above the short call options at expiration, but still within the protective “wing” of the long call, both of the short options would be in-the-money and still have value. The in-the-money short options would need to be repurchased. The difference between buying back the short options, selling the lower call option with value remaining, and the original debit paid would equal the trade’s profit or loss.
If the stock price is below the short options at expiration, the short calls and higher long call will expire worthless, and the lower long call would need to be closed. The credit received for selling the call option, minus the debit originally paid, would equal the profit or loss on the trade.
Time Decay Impact on a Call Butterfly
Despite being net long for the strategy, time decay, or theta, works in the advantage of the call butterfly. Every day the time value of an options contract decreases, which will help to lower the value of the two short calls. Ideally, the underlying stock experiences minimal movement, and theta will exponentially lose value as the strategy approaches expiration. If the long call is exited before expiration, the decline in time value may allow the investor to purchase the options contracts for less money than initially sold, while the in-the-money long option will retain its intrinsic value.
Implied Volatility Impact on a Call Butterfly
Call butterflies benefit from a decrease in the value of implied volatility. Lower implied volatility results in lower option premium prices. Ideally, when a call butterfly is initiated, implied volatility is higher than where it will be at exit or expiration. Lower implied volatility will help to decrease the value of the two short call options more rapidly. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the short options.
Adjusting a Call Butterfly
Call butterflies may be adjusted before expiration to extend the trade duration or rebalance the short strikes if the underlying stock price has moved away from the profit zone. Because call butterflies are net debit strategies, adjustments will most likely come with additional cost to the position, which will increase the risk, lower the profit potential, and narrow the break-even points. Furthermore, because call butterflies consist of two short contracts, assignment is a risk any time before expiration.
External factors, such as dividends, may need to be considered when deciding to adjust or close a call butterfly position. If an investor wants to avoid assignment risk, and/or needs to extend the trade into the future to allow the strategy more time to become profitable, the entire position can be closed and reopened at a future expiration date with the same strike prices or new positions.
Rolling a Call Butterfly
Call butterflies require the underlying stock price to be at or near a specific price at expiration. If the position is not profitable and an investor wishes to extend the length of the trade, the call butterfly may be closed and reopened for a future expiration date. Because more time equates to higher options prices, the rollout will typically cost money and add risk to the position. If the stock price has moved away from the short call options, there may be an opportunity to close the existing position and reopen a new call butterfly with new strike prices closer to the underlying asset’s current price. However, doing so would not make sense if the new net debit paid exceeds the spread's width, as the position could no longer be profitable.
Hedging a Call Butterfly
It is difficult to hedge long call butterfly positions because the strategy relies on a specific price target to be profitable. Because the strategy is entered with limited risk by its structure, follow-up action in the form of a hedge is often unnecessary. Long call options are purchased to provide protection against significant moves from the underlying asset. Therefore, the risk is strictly defined at trade entry.
Call Broken-Wing Butterfly
A call broken-wing butterfly is similar to the long call butterfly in structure, with slight variations. Call broken-wing butterflies consist of buying one in-the-money long call, selling two out-of-the-money short calls, and buying one out-of-the-money long call above the short calls. Call broken-wing butterflies are still a bull call spread and bear call spread centered at the same strike price. However, the out-of-the-money long call option above the short strikes is not equal distance from the out-of-the-money long call option below the short strikes.
When purchasing the long call option above the short calls, at-least one strike price is skipped, thus creating a “broken-wing.” Because of this, the strategy typically receives a net credit at entry. Call broken-wing butterflies are slightly bullish and, like call butterflies, are positively impacted by time decay and decreasing volatility. An ideal scenario would be for the underlying stock price to close at the short strike prices at expiration. However, if opened for a credit, no price movement or a decline in price would still result in a profit.
The maximum profit potential is the original credit received plus the width of the bull call spread, and is realized if the stock closes at the short call options. The maximum risk is the width of the spread below the short strikes, minus the credit received. The break-even price is the skipped strike price plus the credit received.
For example, if a stock is trading at $98 and an investor believes it will increase some, but not a lot, a call broken-wing butterfly may be entered by purchasing a $95 long call, selling two calls at $100, and buying a long call at $110. If the trade collects $1.00 of credit, the maximum profit would be $600 if the stock closed at $100 at expiration, because the long call would have $5.00 of intrinsic value, plus the initial credit received. The short calls and out-of-the-money long call would expire worthless. The maximum risk is -$400 if the stock closes at or above $110. If the stock is at $110, for example, the $95 long call would have $15 of intrinsic value, but the two short calls would each be $10 in-the-money ($15-$20+$1 credit received = -$4). The break-even price is $106 because the $95 call would have $11 of intrinsic value, but the short calls would each be $6.00 in-the-money, plus the $1.00 credit received. If the stock were to drop below the long call at $95, all options would expire worthless, and the initial $1.00 credit would remain as profit.
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