Debit/Debit Spread Strategy:
Butterfly Option

AKA: Long Call Butterfly, Long Put Butterfly

ANALOGY/METAPHOR: Opening a Bird's Cage and Then Betting/Hoping the Bird Won't Fly Away

ACTION: Buy 2 call options, one in the money (ITM) and one out of the money (OTM), and then sell 2 at the money (ATM) call options. This will result in a net debit which represents the maximum amount you can lose. The maximum gain occurs if the stock finishes at the strike price of the 2 short ATM calls so that everything expires worthless except for the single ITM call.

DESCRIPTION: The butterfly option can seem rather complicated to grasp. But the easiest way to understand it is to note how it's actually constructed. It is comprised of a bull call spread and a bear call spread. A further quirk is that the bull call and bear call spreads are written so that the short call portions of each spread are both ATM.

Typically, the "long" portion of these bull and bear spreads would be written ATM or even a little OTM, and the "short" portion of the spreads would be written OTM. You make money if and when the stock moves toward the strike price of these secondary, short OTM options.

With the butterfly option, you also make money as the stock moves toward the strike price of the short calls. But since the stock is already at that strike price (ATM) when you set up the trade, it's already where you want it to be. Therefore, you don't want it to move.

It's a strange little spread. By constructing an overlapping bull call spread and a bear call spread, you seem to be betting that the stock will both go up and go down, all the while hoping that neither happens. You make the maximum amount of profit when the stock finishes where it starts--when all the options expire worthless except for the one ITM call.

EXAMPLE: The XYZ Zipper Company is trading around $40/share. You expect (hope) that the stock will remain relatively flat in the near term.

You essentially open a bull call spread (buying a $35 ITM call for $6/contract and selling/writing an $40 ATM call for $1.50/contract) followed by opening a bear call spread (selling another $40 ATM Call for $1.50/contract and buying a $45 OTM Call for $.50/contract).

Excluding commissions, the long call butterfly spread in this example generates a debit of $3.50. It costs $350 to set up--$600 to buy the ITM call plus $50 to buy the OTM call minus the credit you receive for writing the two calls ATM for $300 ($1.50 x 2).

Ideally, if the stock closes at $40/share, all the calls expire worthless except for the one you purchased with the $35 strike price which would end $5 ITM. As a result, the butterfly option that cost you $300 to set up ends up with a final value of $500.

That's the best case scenario. If the stock doesn't stay flat and instead moves very much in either direction, you can quickly lose your entire original investment:

• If, for example, the stock closes at $35/share (or below), all four calls (and your entire position) would expire worthless.
• If the stock closes at $45/share (or above), you also lose all of your original investment. The math: At $45/share, your $35 long call is worth $1000 and your $45 long call is worth nothing. The two $40 short calls are both $5 ITM and are therefore also worth $1000. They cancel out your ITM call.