Long call butterfly strategy is a powerful and versatile options trading strategy that can be used to capitalize on a variety of market conditions. It combines the use of long call options in order to take advantage of an increase in the underlying stock’s price, while also limiting an investor’s risk exposure.
What is derivative trading?
Derivative trading refers to the practice of buying and selling financial instruments, such as options and futures contracts, whose price is based on an underlying asset. This type of trading allows investors to speculate on the future movement of prices without actually owning the underlying asset. For example, a trader could buy a call option on a stock with the expectation that its price will increase in the future. One popular derivative trading strategy is known as the Long Call Butterfly Strategy.
6 Things to know before doing derivative trading
#1 Market conditions: Keep yourself top of market conditions, such as volatility, liquidity and the volume of trading. The market conditions could have significant effects upon the efficiency of derivatives.
#2 Understanding the asset: Do some research on the market trends of the underlying asset as well as price fluctuations and overall performance in order to make educated decision-making.
#3 Terms of the contract: Learn and comprehend the conditions and terms that apply to the derivative contract including dates of expiration and strike prices and the settlement method.
#4 Counterparty risk: Think about the creditworthiness of the company with whom you trade. Check to see if the company has a good reputation and stability in its finances to meet their obligations.
#5 Margin requirements: Know the margin requirements of your derivative contracts, such as the initial margin as well as the maintenance margin. Make sure you have sufficient funds to satisfy the conditions.
#6 Risk management: Design a risk-management strategy that incorporates stop-loss order as well as position sizing and diversification. This will help you limit risks and limit losses effectively.
A long butterfly option strategy
The long call butterfly strategy is a complex options trading strategy. It involves the purchase of two call options, the sale of one call option, and the writing of another call option. This strategy is designed for investors who are expecting significant price movement in a stock but are uncertain as to which direction this movement will occur.
You can also say that the long call butterfly is therefore a neutral strategy that can be used by traders who believe the stock will move in either direction. The underlying principle behind this strategy is to generate a profit if the price of the underlying asset moves lower, without incurring any losses if it moves higher
an example of a long butterfly option strategy.
Example of Long Call Butterfly Strategy
As you know, in order to execute this strategy, traders purchase one at-the-money call option, sell two out-of-the-money call options, and buy another at-the-money call option with a higher strike price than the first one. The goal is for the price of the underlying asset to stay between the two middle strike prices until expiration.
Buy XYZ 1 In the money Call option
Buy XYZ 1 Out of the money call option
Sell XYZ 2 At the money call option
Bigger profit is made when the price of the stock is at or above the price at which you strike call options (center strike) at the time of expiration. The highest risk is the total cost of the strategy, including commissions, and it is realized if the price of the stock is at or above the strike price at the top or lower than the strike price that is lowest at expiration. To know more about trading strategy you can download a best trading app which features tons of indicators & charts to trade in the derivative market.
When to implement a butterfly strategy?
If there is a low level of volatility in the markets and the expectation of moderately upward movements in prices of stocks, using the butterfly strategy could be profitable. The purpose for this method is to make money from fluctuations that are small while limiting losses. It restricts both profits and losses by creating distinct loss and profit thresholds.
However, it is vital to keep in mind that this method requires exact timing and an in-depth study of the market’s conditions. Furthermore, the cost of transactions should be considered prior to making this trade. In the end, whether you have to use a butterfly strategy will be based on your personal objectives for investment and risk-tolerance levels.
- The Long Call Butterfly spread should be considered when you anticipate the assets involved to trade in a narrow price range, as this strategy takes advantage of the time decay.
- But, unlike Short Strangle as well as Short Straddle the risk danger of the case of a Long Call Butterfly is limited.
- If your implied volatility on the base assets rises unexpectedly, and you anticipate the volatility to decrease then you should consider applying to the Long Call Butterfly strategy.