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Visually Analyze Option Strategies
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Long Call Butterfly

 

Description

 

The Long Call Butterfly is another rangebound strategy and is the opposite of a Short Call Butterfly, which is a volatility strategy.

 

Long butterflies are quite popular because they offer a good risk/reward ratio, together with low cost. The long options at the outside strikes ensure that the risk is capped on both sides, and this is a much more conservative strategy than the Short Straddle.

 

The Long Call Butterfly involves a low strike long call, two at-the-money short calls, and an out-of-the-money long call. The resulting is profitable in the event of rangebound action by the stock. Although the risk/reward ratio is attractive, the problem is that the maximum reward is restricted to the scenario where the stock is at the middle strike at expiration.

 

Market Opinion

 

Directional neutral. You expect little movement in the price of the stock.

                  

P/L

 

 

 

 

 

 

 

When To Use

 

Use this strategy when you expect the stock not to move very much, and can execute a high-yielding trade at low cost for capital gain purposes.

 

Example

 

XXXX is trading at $50 on May 12, 2011.

Buy June 2011 45 strike call for $6.12.

Sell two June 2011 50 strike calls at $3.07.

Buy June 2011 55 strike call for $1.30.

 

Benefit

 

The benefit is that, for little monetary outlay, you can profit from a rangebound stock with capped risk.

 

Risk vs. Reward

 

The risk is the net debit of the options you bought and sold. The reward is the difference between adjacent strikes minus the net debit.

 

Net Upside

 

The difference between strikes minus net debit.

 

Net Downside

 

Net debit paid.

 

Break Even Point

 

Break even up: higher strike minus net debit.

 

Break even down: lower strike plus net debit.

 

Effect Of Volatility

 

Low volatility in the stock price is what you are looking for.

 

Effect Of Time Decay

 

Positive when the position is profitable and negative when the position is not profitable. Entering the trade, the stock is profitable, so from then on the effect of time decay is negative on the position.

 

Alternatives Before Expiration

 

Unravel the position if the stock moves outside of the stop loss areas below or above the stock price.

 

You can unravel it just before expiration.

 

Alternatives After Expiration

 

Close out the position by buying back the options you sold and selling the options you bought.

 
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