Advanced Options: A Theoretical Long Call Butterfly Spread

              

In Wednesday's edition of Advanced Options, we analyzed the long call butterfly spread, which allows accurate option veterans to profit from a stock's apathetic price action. In today's column, we're going to make this three-tiered strategy even more tangible by analyzing a theoretical long call butterfly on agricultural equipment issue AGCO Corporation (AGCO: sentiment, chart, options).

A Brief Look at the Butterfly

Before we dissect our hypothetical strategy, let's quickly recap what we know about the long call butterfly. The option play should be utilized by investors expecting little volatility from a stock in the short-to-intermediate term. More specifically, the strategist should have a specific price target in mind, as precision is needed to reap a profit.

The long call butterfly is simply a combination of a long call spread and short call spread, with the two strategies converging at the sold strike. More specifically, to implement the play, the trader would buy one in-the-money call and one out-of-the-money call, while simultaneously selling two at-the-money calls – all with the same expiration month.

The sold strike should correlate with the aforementioned price target, which is where the underlying security needs to finish at options expiration in order for the spread to profit. However, the maximum potential reward is limited to the difference between the sold strike and the lower strike, minus the net debit paid. On the flip side, the most the strategist can possibly lose is capped at the initial net debit.

(Don't forget to include any margin requirements, brokerage fees or commission costs in your calculations.)

Hunting for a Butterfly

So, why did we single out AGCO for our hypothetical long call butterfly? In simplest terms, the stock has remained range-bound during the past few months, and the company isn't slated to report earnings (which often spark significant price swings) again until February, according to Thomson Reuters.

Technically speaking, the shares of AGCO have been rather subdued since May, stagnating between support in the $25-$26 region and resistance in the $32 neighborhood. What's more, taking a closer look at the charts reveals an even tighter trading range, with the equity pinned between its 20-week and 50-week moving averages since mid-September. At last check, the security was hovering in the upper portion of this now-familiar territory, hanging out near the $29 level.

Initiating the Play

To implement our long call butterfly, we're going to center on the December 30 strike for our sold calls, as this is the closest available strike to our intermediate-term target. These back-month options were last bid at $1.35 each, meaning we would receive a combined premium of $2.70 for writing the calls.

For the "wings" of our butterfly, we're going to buy the in-the-money December 25 call, which was last asked at $4.70, as well as the out-of-the-money December 35 call, which last crossed the tape for $0.25. Since the combined premium of $4.95 paid for the bought options exceeds the $2.70 received from the sold options, our butterfly spread was initiated for a net debit of $2.25.

To avoid losing our net debit – which represents our maximum risk on the play – we need the shares of AGCO to remain inhibited between two breakeven rails by December options expiration: the $27.25 level (25 + $2.25), and the $32.75 level (35 - $2.25). These two breakeven levels correlate well with the stock's trajectory during the past few months (though an available option at the December 27.50 strike would've been slightly more ideal for our sold calls).

Should the shares of AGCO finish at the $30 level when December options expire, our two sold calls and the higher-strike bought call would expire worthless, while the December 25 call would be in the money. Nevertheless, even if our goal is achieved, our maximum potential profit is capped at $2.75 ([30 – 25] - $2.25).

Before You Begin...

In conclusion, investors embarking on this option-trading journey should target range-bound stocks with a lack of potential momentum-inducing catalysts (i.e. – earnings, drug-trial data, etc.) to spark a significant move higher or lower. Furthermore, while the reduced risk of the long call butterfly spread can be quite appealing, the odds of accurately pinpointing a stock's short-term trajectory – as well as the maximum potential gain on the play – are quite slim. As such, only veteran option traders with a skill for precision should try caging a profit with the butterfly.