A Long Call Butterfly is to be adopted when the investor is expecting very little movement in the stock price or index. The investor is looking to gain from low volatility at a low cost. The strategy offers a good risk/reward ratio, together with low cost. A long butterfly is similar to a Short Straddle except your losses are limited. The strategy can be done by selling 2 ATM Calls, buying 1 ITM Call, and buying 1 OTM Call options (there should be equidistant between the strike prices). The result is positive in case the stock/index remains range bound. The maximum reward in this strategy is however restricted and takes place when the stock/ index is at the middle strike at expiration. The maximum losses are also limited.
When to use: When the investor is neutral on market direction and bearish on volatility.
Risk: Net debit paid
Reward: Difference between adjacent strikes minus net debit
Break even point:
Nifty is at 3200. Mr. XYZ expects very little movement in Nifty. He sells 2 ATM Nifty Call Options with a strike price of Rs. 3200 at a premium of Rs. 97.90 each, buys 1 ITM Nifty Call Option with a strike price of Rs. 3100 at a premium of Rs. 141.55 and buys 1 OTM Nifty Call Option with a strike price of Rs. 3300 at a premium of Rs. 64. The Net debit is Rs. 9.75.
Strategy: Sell 2 ATM Call, Buy 1 ITM Call option and Buy 1 OTM Call Option