Bull Spread — Long OTM Call Butterfly

Bull Spread

Long OTM Call Butterfly

Yes, i know how intimidating this high sounding name can be. So, let me attempt to explain what this Bullish Spread is about, in a way that even I can understand.

The simplest definition of a Long Call Butterfly is this. Long Call Spread + Short further OTM Call Spread

For our example to illustrate the Long OTM Call fly, we will use SPY (SP500 Index ETF). SPY is currently trading at 123.60

Long +1/-1 SPY Sept124/126Call and Short -1/+1 Sept126/128Call

Breaking this down granularly, it is:

Long SPY Sept124Call and Short SPY Sept126Call (which is a Long Call Spread)

Short SPY Sept126Call and Long SPY Sept128Call (which is a Short Call Spread)

As you have read, this Long Call Spread is a bullish position, which has limited profits and limited losses. Hence, limited risks in exchange for limited rewards. Similarly, this accompanying Short Call Spread, will also have limited upside and downside. Hence, in a gist, a Long OTM Call fly is a limited risks and limited reward position.

Under normal circumstances, a fly is an affordable option strategy with the aim of reaping multi-fold returns. This can occur but the probability of this event occurring, is correspondingly low. Low probability of success, translates to lower cost of this trade; fair.

When to use. Mild Bullish Outlook

How to establish. LONG OTM Call Spread and Short further OTM Call Spread

Debit or Credit. Usually a small debit

Margin Requirement. Yes

What is the Maximum Profit. Limited

What is the Maximum Loss. Limited

Profit/Loss Explanation

Debit of Long 124/126Call Spread: -0.84

Credit of Short 126/128Call Spread. +0.50

Total NET Debit = -0.34

Max Profit. 1.66 (strike 126 — strike 124 — 0.34 debit paid)

Max Losses. 0.34

Breakeven Points. 124.34 (124 +0.34) and 127.66 (128 — 0.34)

Profitable Range. SPY between 124.34 and 127.66

Take this opportunity to solidify this calculation concept. Once understood, it will help with understanding future examples.

Basically, the Long Call Spread of this fly has a maximum profit of 2 (126 — 124). But you have already paid 0.34 for this position, and so, in reality, the Max Profit can only be 1.66 (2 — 0.34). Only if SPY trades above 124.34 at expiration, will this position be profitable. Hence the breakeven point is 124 +0.34.

Similarly, the max that you can lose on the Short Call Spread is also 2 (128 — 126). But in order that you do not lose more than 2, you must account for the initial 0.34 debit paid. Hence, the second breakeven point is 127.66 (128 — 0.34).[/i]

Risk/Reward Returns. 0.34 /1.66 = 20.5% in 9 calendar days or 830% annualized returns.

With such a high risk/reward returns, one can expect that the probability of success for this trade, is low. This is the trade off. Think of it as paying 50cents for a TOTO ticket. It pays very handsomely if your TOTO numbers are picked; but that’s a slim chance. Consequently, you only need to pay a small price for this chance, a mere 50 cents.

Therefore, just remember that a Long Butterfly is like buying TOTO. small saw to chop a big tree.

P/L Ch art — Long +1/-2/+1 SPY Sept 124/126/128 Call Butterfly