Introduction
The Long Butterfly Spread is a low-risk, limited-profit options trading strategy designed for markets with low volatility. This strategy allows traders to take advantage of small price movements while keeping risk limited. The Long Butterfly Spread is ideal for traders who expect the underlying asset to stay near a specific price level at expiration.
In this blog, we will explore the Long Butterfly Spread, how it works, its benefits and drawbacks, and how to implement it using Algomojo.
What is a Long Butterfly Spread?
A Long Butterfly Spread is an options strategy that involves combining a bull call spread and a bear call spread to create a position with limited risk and reward.
Structure of a Long Butterfly Spread
The strategy consists of three strike prices and four options contracts:
- Buy 1 lower strike call option (ITM)
- Sell 2 at-the-money call options (ATM)
- Buy 1 higher strike call option (OTM)
This structure ensures that maximum profit is achieved when the underlying asset remains close to the middle strike price at expiration.
Example of Long Butterfly Spread
Assume Stock XYZ is trading at ₹100, and you execute the following trades:
- Buy 1 call option at ₹95 (ITM)
- Sell 2 call options at ₹100 (ATM)
- Buy 1 call option at ₹105 (OTM)
If XYZ stays at ₹100 at expiration, you achieve maximum profit because the short calls expire worthless while the long ITM call holds value.
Key Takeaways
- Neutral Strategy: Best for markets with low expected volatility.
- Limited Risk: Maximum loss is limited to the net premium paid.
- Limited Profit: Profit is capped at the middle strike price.
- Time Decay Advantage: Gains from time decay as the short calls lose value faster than the long calls.
Payoff Structure of Long Butterfly Spread
- Maximum Profit: Occurs when the underlying price is at the middle strike price at expiration.
- Maximum Loss: Occurs when the price moves significantly away from the middle strike price.
- Break-even Points: Two break-even levels exist:
- Lower Break-even = Lower Strike + Net Premium Paid
- Upper Break-even = Higher Strike – Net Premium Paid
Advantages of a Long Butterfly Spread
- Low Capital Requirement: Requires lower margin compared to naked options.
- Defined Risk and Reward: Fixed maximum loss and profit.
- Neutral Market Strategy: Works well when volatility is low.
Risks and Considerations
- Limited Profit Potential: Gains are capped if the underlying remains at the middle strike.
- Impact of Volatility: If volatility rises, the trade may not reach the desired profitability.
- Liquidity Concerns: Entry and exit spreads may widen, increasing slippage costs.
Step-by-Step Implementation in Algomojo
With Algomojo, traders can execute a Long Butterfly Spread seamlessly. Here’s how:
1. Create a Buy Call (ITM) Order
- Path: My Strategy => New Strategy
- Select an expiration date and an in-the-money (ITM) call option.
2. Create a Sell Call (ATM) Order
Path: My Strategy => New Strategy
Select an at-the-money (ATM) call option and sell two contracts.
3. Create a Buy Call (OTM) Order
- Path: My Strategy => New Strategy
- Select an out-of-the-money (OTM) call option.
4. Group Your Strategy
- Path: My Group Strategy => New Group Strategy
- Combine the three legs into a single strategy group.
5. Enable Paper Trade Mode
- Path: My Group Strategy
- Enable Paper Trade mode to test the strategy before executing it live.
6. Generate BUY Signal to Open the Trade
- Path: My Group Strategy
- Execute a BUY signal to enter the Long Butterfly Spread.
7. Executed Paper Trade Orders
- Path: My Group Signals => Orders
- Ensure all contracts have been filled at your intended strike and expiration.
8. Monitor Open Positions
- Path: My Group Signals => Positions
- Track how the underlying price moves relative to the middle strike.
9. Generate SELL Signal to Exit
- Path: My Group Strategy
- If the price remains near the middle strike, trigger a SELL signal to close the trade.
10. Confirm Closing Orders
- Path: My Group Signals => Orders
- Ensure all contracts have been properly closed.
11. Review Trade Performance
- Path: My Group Signals => Positions
- Evaluate the profit/loss and assess the impact of market conditions on strategy performance.
Frequently Asked Questions (FAQ)
Is a Long Butterfly Spread better than simply buying calls?
Yes, if you expect the market to stay within a range. A Long Butterfly Spread has lower risk and cost than buying naked calls.
What happens if the stock moves beyond the upper or lower break-even points?
The maximum loss is limited to the net premium paid for the strategy.
Can I use Put options for a Long Butterfly Spread?
Yes, you can create a Long Put Butterfly Spread with puts instead of calls.
Does this strategy work for high volatility markets?
No, the Long Butterfly Spread is best for low volatility markets.
Can I execute this strategy manually?
Yes, but platforms like Algomojo automate execution, reducing manual errors.
Final Thoughts
The Long Butterfly Spread is a great strategy for traders who expect minimal price movement and want a low-risk, limited-reward setup. Using Algomojo, traders can efficiently execute, monitor, and refine this strategy with automated multi-leg execution and real-time tracking.
Have you tried a Long Butterfly Spread before? Share your experience in the comments!