DESCRIPTION: A call butterfly is constructed by selling two calls and buying 1 call above and below that level. The upper and lower strikes (wings) are usually equidistant from the middle strike (body), and all the options have the same expiration date. This is another way for investors to sell realized volatility.
MOTIVATION: The investor who buys a call butterfly is predicting that the price of a stock will not move very much between the time the trade is made and options expiration. The hope the share price will close out at the strike price of the option sold. We call this a “thread the needle” trade as there is one price maximizes profits.
| Action | Quantity | Expiration | Strike | Type | Net |
| Buy | 1 | 0.25 Years | $30.00 | Call | $0.37 |
| Sell | 2 | 0.25 Years | $25.00 | Call | -$3.48 |
| Buy | 1 | 0.25 Years | $20.00 | Call | $5.17 |
| Debit | $2.06 |
OUTLOOK: The buyer of a call butterfly maximizes their profits if the price of the underlying security changes very little and settles at a particular price. An investor might want to use this strategy if they had a strong view that the price of an asset would be at a certain price at a certain time.
MAXIMUM GAIN: (Middle Strike – Lower Strike) – Premium Paid
The investor will capture the highest return if the asset price sits at the strike price of the middle call option. This allows it to expire worthless. This leaves the investor with an in the money call which they sell or exercise to take position of the stock, should they wish to do so.
MAXIMUM LOSS: Premium Paid
The most one can lose is the debit paid to initiate the trade.
BREAKEVEN: Middle Strike + Premium Paid , Middle Strike – Premium Paid
The breakeven level is the point where the share price moves away from the center strike call by an amount equal to the premium paid to put on the trade.
VOLATILITY: Somewhat Negative. The sensitivity of the center call to a change in implied volatility is lager than the options at the winds. In other words, it is negative vega. Therefore an increase in implied volatility will have a negative impact on the value of a call calendar spread.
TIME DECAY: Positive. Time decay is the primary driver of returns on the call calendar spread. This structure produces the highest return when the share price ends at the price of the center strike, which expires worthless.
ASSIGNMENT RISK: Significant. An American call option allows the owner of that call to take position at any time. The lower strike call is deeply in the money and therefore subject to early exercise. Cost of carry makes early exercise uneconomic, unless the company pays a significant dividend. The owner of the call, may want to exercise to capture that dividend.
EXPIRATION RISK: Significant. This strategy has extreme dividend risk and there are three points where deciding to exercise or waiting for the owner of the middle call to decide to exercise or not.