The 1-2-1 option strategy, often referred to as a long call butterfly, is a limited risk options trading approach that involves a specific combination of call options with different strike prices. It's designed to profit when the price of the underlying asset is near the strike price of the short calls at expiration.
Understanding the Long Call Butterfly
The long call butterfly is constructed using three call options, adhering to a 1-2-1 ratio as stated in the reference. Here's a breakdown:
- Buy One ITM (In-The-Money) Call: Purchase one call option where the strike price is below the current market price of the underlying asset.
- Sell Two ATM (At-The-Money) Calls: Sell two call options where the strike price is approximately equal to the current market price of the underlying asset.
- Buy One OTM (Out-of-The-Money) Call: Purchase one call option where the strike price is above the current market price of the underlying asset.
Example of a 1-2-1 Long Call Butterfly
Let's say the underlying asset is trading at $50. A long call butterfly strategy might involve:
- Buying one call option with a strike price of $45 (ITM).
- Selling two call options with a strike price of $50 (ATM).
- Buying one call option with a strike price of $55 (OTM).
The profit potential is highest when the price of the underlying asset is at or near the strike price of the short calls ($50 in this example) at expiration. The maximum loss is limited to the net premium paid for setting up the strategy.
Key Characteristics
- Limited Risk: The maximum loss is capped at the initial cost of setting up the trade.
- Limited Profit: The maximum profit is achieved when the underlying asset's price is at the strike price of the two short calls at expiration.
- Neutral to Slightly Bullish: This strategy benefits from a relatively stable or slightly increasing price of the underlying asset.
When to Use this Strategy
Traders typically employ the 1-2-1 long call butterfly strategy when they anticipate:
- Low volatility in the underlying asset.
- The price of the underlying asset will remain within a defined range until expiration.
Advantages and Disadvantages
| Feature | Advantage | Disadvantage |
|---|---|---|
| Risk | Limited and known upfront. | Profit potential is limited. |
| Profit | Potential to profit if the price of the underlying asset is near the short strike price at expiration. | Requires precise prediction of price movement; can be unprofitable if the price moves significantly. |
| Volatility | Benefits from low volatility; high volatility can erode profits. | Time decay can negatively impact the strategy, especially as expiration approaches. |
