On March 10, 2010, the USDA released its monthly crop production report indicating that carryout for this year’s soybean crop would be at 190 million bushels, down from last months estimate of 210 million bushels. Analysts were widely expecting a range of 194 to 196 million bushels. The USDA also cut production figures from 3.361 billion bushels to 3.359 billion bushels further adding to support. I think a bull-call butterfly spread in this market enables a trader to enter this market with clearly defined risk, while providing a large range for the trade to turn a profit.

Simply, the bull call butterfly spread is a bullish strategy that is a combination of a bull-call spread and a bear credit spread. The trade has limited profit potential and limited risk. It involves three strike prices and can be constructed on either the call side or the put side.

The basic construction on a bull-call butterfly spread is to buy a call at a lower strike and also a higher strike, while selling two calls at the same strike in the middle of the two calls purchased. It may sound complicated, but after an example, you should have a firm grasp of the construction, risks and profit potential.

Construction
A.    Buy one (at- or slightly out-of-the-money) call option.
B.    Sell two call options at a higher strike.
C.    Buy one option that is equal distance from the first bought and the two sold.

Example:
Buy 1 July soybean \$10 call at 34 cents
Sell 2 July soybean \$11 calls at 12 cents
Buy 1 July soybean \$12 call at 5 cents

Ex. Cost of spread 34 cents (\$10 call) + 5 cents (\$12 call) – 24 cents (\$11 calls *2) = 15 cents
Remember, soybeans are \$50 per cent move; so \$50 *15 cents = \$750

Breakeven occurs by taking the premium paid for the spread plus the plus transaction (commission) costs, added to the lower strike bought and also subtracted from the highest option bought.

BE 1 = Lower option Strike bought + net premium paid + transaction costs
BE 1Ex. = \$10 call + 15 cents + transaction costs = \$10.15 + transaction costs
BE 2 = Higher option Strike bought – net premium paid – transaction costs
BE 2 Ex. = \$12 call – 15 cents = \$11.85 – transaction costs.

One of the benefits of the bull-call butterfly spread is the ability to purchase a near-the-money call option with minimal out-of-pocket expense. The maximum profit potential occurs when at expiration of the options the futures market is trading at the center strike price (the two options sold).  In this example, July soybeans at \$11 at expiration will provide the maximum profit potential.

Max profit =Strike price of short call – strike price of lower bought call – net premium paid – transaction costs
Max profit ex. \$11 (short call) – \$10 (lower long call) – 15 cents – transaction costs =85 cents – transaction costs. =85 cents * \$50 = \$4,250 – transaction costs
Max Loss= Net premium paid + transaction costs
Max Loss ex. = \$750 + transaction costs
Expiration is June 25, 2010.