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Today we're starting a new, more advanced series on the butterfly strategy. We'll ultimately go though every
type of butterfly known to man - skip strike or modified, ratio, Christmas trees to name just a few - and show
how to put on the trade and how it can be used as a ordinary strategy or as a hedge for trades gone bad.
Before we run ahead, though, we should warm up with a little with a discussion about the standard butterfly.
What's a long butterfly?
A butterfly is three legged ratio strategy; we'll be starting with long butterfly spreads with calls below.
Butterflies have a very enticing profit and loss graph at expiration: the graph shows very little downside risk
relative to the upside potential. When you buy a butterfly, it's usually entered all as one trade from the
TradeKing butterfly trade screen and often the butterfly view in the option chain page is the starting point to
enter the trade.
A long butterfly spread with calls is a combination of a long call spread and a short call spread, with the
spreads converging at the middle strike price - in this example, we're talking about a stock trading currently
at 42.50. Ideally, you want the calls with the 42.50 and 45 strikes to expire worthless, while you capture the
maximum intrinsic value of the in-the-money call with the 40 strike. In theory this can only occur if the stock
closes at expiration just below the middle strike (42.50). NOTE: Strike prices are equidistant, and all options
have the same expiration month.
Because you're selling the two at-the-money options with the middle strike (42.50), butterflies are a relatively
low-cost strategy. So the risk vs. reward can be tempting. However, the odds of hitting the sweet spot are
fairly low.
Constructing your butterfly spread with the middle strike (42.50) slightly in-the-money or slightly out-of-themoney may make it a bit less expensive to run. This will put a directional bias on the trade. If the middle
strike is higher than the current stock price, this would be considered a bullish trade. If middle strike is below
the current stock price, it would be a bearish trade. (But for simplicity's sake, if bearish, puts would usually be
used to construct the spread).
As expiration nears...
Let's work through an example and talk about the butterfly and how it gains in value as expiration
approaches.
We put on this butterfly with the stock exactly at the strike, 42.50 buying one 40 call, selling two 42.50 calls
and buying one 45.00 call; all of these calls have 45 days to expiration. So we have a neutral outlook on the
stock since the middle strike is equal to the current stock price.
As we can see in the graph it's only in the last week to expiration that the butterfly really starts to gain in
value. So now many of you might think: okay, so I'll do the trade on day 7 then, if that's when the money
really hits - but the tradeoff is a big increase in initial cost. At day 7 the same trade yields more, but now it
costs you $59 vs $35 (70% more). What's more, the stakes are substantially higher, too: if the stock does
start moving away from the strike, since we're so close to expiration the losses will pile up quickly. (my post
on the Greek gamma will make this concept a little clearer). Many traders who trade butterflies as a
standalone strategy do many of them at once (not just a one lot) and play the position in its earlier stages.
When the percentage gain starts to look good (e.g. buy on day 45, sell on day 21), they'll get out of the trade
and not wait for the homerun at expiration. That is, they choose not to take the risk of losing all the gains in
the last week in a fairly unlikely hope that the stock will finish bang-on at the strike.
Many, many uses for butterflies...
Traders use butterflies for almost the full gamut of trading possibilities: for speculation, as described above,
for hedging, for volatility plays, even as a rolling feature to help recover from a trade gone bad. Next week
we'll move to another speculative variation, the split-strike butterfly, and then progress through the various
types until we've covered all these angles. As you can see, butterflies pack a lot of variety into one general
trade type. We'll explore benefits and risks to each type of butterfly as this series progresses
Skip -strikes with calls = short call spread + long butterfly spread call
You can think of this play as embedding a short call spread inside a long butterfly spread with calls,
discussed in last weeks post. Essentially, you're selling the short call spread to help pay for the butterfly.
Because establishing each trade independently would entail both buying and selling a call with 45 strike in
this example, they cancel each other out and 45 strike becomes a flat position. Obviously the buy and sell of
the 45 strike just generates unnecessary commissions so that is why we just skip that strike.
The embedded short call spread makes it possible to establish this play for a net credit (as in this example)
or a relatively small net debit. [Butterfly -.30, Short Spread +.45, net +.15] However, due to the addition of the
short call spread, there is more risk than with a traditional butterfly. The short spread has a margin
requirement equal to the difference between the embedded short spread strike prices, in this case 2.50
(47.50 45).
Normally a skip-strike butterfly with calls is established with the stock below the lowest strike (40 call in this
example), making it more of a directional play than a standard butterfly. This is done mainly because of the
risk the short spread creates. Ideally, you want the stock price to increase somewhat, but not beyond 42.50
strike. If all goes well, the underlying does finish just below 42.50, the calls with 42.50 and 47.50 will
approach zero, but you'll retain the intrinsic value for the call with the 40 strike. When done for a net credit,
though, it becomes interesting: if the stock goes the wrong direction (down) the trade can still be profitable.
All the options would expire worthless, and you would make the net credit received. Please see the Profit
and Loss graph at expiration below for a fuller explanation of how this works.
P&L graph
As the P&L graph below shows, your hope here is that the underlying will bump up from its current level to
42.50 strike at expiration, and then stay there until expiration. If that happens, youll collect any premiums for
the calls you sold at 42.50, plus youll capture the intrinsic value on the ITM call at 40 call. That call at 47.50
strike is merely there for insurance: in case the market sky rockets beyond 47.50, it caps off the total risk of
the trade.
First, the break-even for this example is 45.15. If established for a net credit (as in this example) then the
break-even point is the 45 Strike (the skipped strike) plus the net credit received (+0.15) when establishing
the play.
If established for a net debit, then there are two break-even points:
* the lowest strike plus net debit paid.
* the skipped strike minus net debit paid.
Your max potential profit is limited to the 42.50 strike minus the 40 strike, plus the net credit received in this
case (42.50 40 +0.15 = +2.65). If done for a net debit it would be the same calculation, minus the debit
paid.
Your max risk is limited to the difference between the highest strike (47.50) minus the skipped strike (45)
minus the net credit received (47.50 45 - 0.15 = 2.35), or plus the net debit paid.
market markers strong suit. Much like the skip-strike, the Christmas tree is usually performed with a bullish
or bearish bias: usually traders use calls if slightly bullish and puts if slightly bearish. The Christmas tree is
usually done for a net debit to the account, and after the trade is paid for there is no additional margin.
A butterfly with a twist
The Christmas tree is basically a standard butterfly with a twist. This twist reduces the overall cost of the
butterfly, but does also reduce the range of prices that the underlying could trade in and still be profitable.
The basic format for a standard butterfly is 1x2x1 - the twist comes in with that ratio, since Christmas trees
are constructed on a 1x3x2 ratio instead. For example, with the stock near or below 40 we would buy one of
the 37.50 calls, sell three of the 42.50 calls and buying two of the 45 calls. Heres a rule-of-thumb to help you
remember the Christmas trees ratio: the number of contracts on the outside or bought options (37.50 and
45 strikes) added together should equal the number of contracts sold at the middle strike (42.50 strike).
The benefit of the lean is that it will be cheaper than doing a standard 5-point-wide butterfly - say, for
example, buy 1 37.50, sell 2 42.50, and buy 1 47.50. So Christmas trees offer an interesting, often more
affordable way to trade butterflies. The down side is if the stock rockets up on the upside (above 42.50) of
the trade (between 42.50 and 45), theres a much smaller range the stock can stay in and still be profitable.
Lets talk about risk (and reward)
Wheres our break-even, max loss and max gain on this trade? Lets review each in turn.
Break-even for Christmas trees happens at two different points: The 37.50 strike plus the net premium paid
(37.50 + 0.65 = 38.15). The second point is the 45 strike minus one-half of the net premium paid (45 0.65/2
= 44.675 call it 44.68 with rounding).
Your max potential profit is limited to the 42.50 strike minus the 37.50 strike, minus the debit paid (42.50
37.50 - 0.65 = +4.35).
Your max risk is limited to the net debit paid for the trade (65 cents) times the number of 1x3x2 ratios filled.
So in this example, since we only entered one 1x3x2 ratio, the total risks in dollars would be .65 x 100 or $65
plus commission. Note: commissions are a non-negligible issue here because there are three legs to the
trade, with a commission charged on each leg of the trade. That said, keep in mind that TradeKing sends
your butterfly to the floor as a single unit, thus making sure your trade gets filled only if the net of all legs
equals the limit debit youre willing to pay. Without that assurance you could easily end up with a half-filled
butterfly thats not really what you were planning on.
Factoring in implied volatility
After youve established a Christmas tree, increasing implied volatility is your enemy. Your main concern is
the options you've sold with the middle strike, or 42.50. An increase in implied volatility will increase the price
of these options, so if you choose to close your position prior to expiration, it will be more expensive to buy
them back.
In addition, you want the stock price to remain stable, but an increase in implied volatility suggests an
increased possibility of a price swing.
You may want to consider running this play using index options rather than options on individual stocks.
That's because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index's
component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.
On the positive note, time decay is helping you out here. Youve sold three calls at 42.50, so to achieve the
maximum profit you hope to buy each of those calls for little to nothing at expiration and capture as much
intrinsic value as possible in that long 37.50 call.
While implied volatility represents the consensus of the marketplace as to the future level of stock price
volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct
One route would be to sell at 2.50, take the loss and move on. That's always available; if this is your stop
loss point think hard about selling and moving on.
Your other route might be to butterfly it, giving yourself a chance to make the money back without adding a
lot of extra capital or risk. Heres how it works.
Original long call:
DRYS at 92.17
Bought 1 June 100 call at 4.60
Stock drops to 87.14
Long call drops to 2.50
Butterfly it:
Buy 1 June 90 call at 5.50
Sell 2 June 95 calls at 3.80
= 2.10 net credit to the account
Already holding 1 June 100 call at 4.60
This position requires no additional margin and brings a 2.10 credit into the account that we didnt have
before (2 x 3.80 = 7.60 5.50). Adding in the 4.60 we already paid for the 100 long call, the total cost of the
butterfly is 2.50 (4.6 2.10). Thats not great, considering the cost of the entire butterfly if we bought it today
all as one trade would be .60 -- but bottom line, we were long a call to start and our forecast was wrong. Now
our outlook has switched to something along the lines of: we dont want the cheese anymore; we just want
out of the mousetrap. If we just sold and moved on we would obviously receive 2.50, so a 2.10 credit does
mean weve taken on .40 of additional risk (as opposed to just selling and getting out).
If we do get lucky and the stock finishes somewhere between 90 and 100, thatd decrease our loss even
more. If we hit a homerun and the stock finishes right at 95 we would make 5 on the butterfly that we paid
2.50 for and be up a total of 2.50 on the entire trade. Realistically, though, our hope is that the stock finishes
at expiration within a 5 point range, between 92.50 and 97.50. This means we succeeded and got out of the
trap with no loss on the entire trade. So we are risking an extra 40 cents to have that chance at breaking
even.
The new break-even and net risk
Again, our break-even points are 92.50 and 97.50. The net risk of the entire position is 2.50, starting with the
long call which we bought for 4.60 and can now sell for 2.50, for a 2.10 loss. Having turned the position into
a butterfly, our total risk is now 2.50 (including the initial long call purchase) and we have a fighting chance.
A few closing points: obviously this move assumes were still bullish on DRYS. You should also keep your
expectation realistic: the ONLY time a butterfly is usually close to the maximum payout is if the stock is right
at the middle strike (95) upon expiration. If it makes the move back to 95 tomorrow the butterfly will not be
close to worth 5 points. See this blog on butterlies for further explanation.
Why is it possible to butterfly?
The short answer: time and volatility are both on our side with this trade. With 24 days left until expiration, its
possible to get a decent credit for a butterfly, as in our example. If it were the last week before June
expiration the credit received to leg into the butterfly would probably not be that enticing. Its also a good
thing that DRYS is a volatile stock; its implied volatility on June ATM options is currently 74%. On a less
volatile stock the credit would once again be a lot less enticing.
Next week
Check back for more variations on this trade next week. Well also examine how the original trade changes
as expiration approaches and see how well this trade set-up fares.
two legs brings in a .90 credit into the account (3 x 5.50 = 16.50, 2 x 7.80 = 15.60, 16.50 15.60 = .90). That
90 cents helps defray the initial cost of the 100 call. Starting with the 4.60 we already paid for the 100 long
call, the total cost of the Christmas tree butterfly is now 3.70 (4.6 .90). Again, this doesnt look great
compared to the cost of a Christmas tree butterfly if we bought it today all as one trade, which is 1.70. But
since our long call isnt moving as wed hoped, this new trade has the potential to break even or profit under
the new conditions.
If we just sold the call and moved on, we would obviously receive 2.50, so a .90 credit does mean weve
taken on 1.60 of additional risk (as opposed to just getting rid of the long call).
The standard butterfly save vs. the Christmas tree
The Christmas tree save described above takes in a smaller credit (.90) versus the credit we received in
last weeks standard butterfly (2.10). So why take this route?
Taking in less of a credit (compared to the standard butterfly) means more up-front risk for the Christmas
tree, but it also provides a much wider sweet spot for breaking even at expiration. If the stock finishes at
expiration somewhere between 88.70 and 96.30 the entire series of trades will break-even. Compare that to
last weeks narrow break-even zone for the standard butterfly; there the stock needs to stay between 92.50
and 97.50 at expiration.
This illustrates a golden rule of options: if you increase your up-front risk, youll usually end up with the
benefit of a wider sweet spot, and vice versa.
Theres another benefit of the Christmas tree over the standard butterfly that might justify accepting that
smaller credit initially. The Christmas tree offers the chance of a bigger homerun if things go your way upon
expiration. Specifically, if the stock finishes right on 90 at expiration, the Christmas tree butterfly should be
worth about 10 (100 Strike 90 Strike) which means the upside for the entire series of trades would be 10
3.70 or 6.30. Compare this to the standard b-fly, where the homerun was a maximum of only 2.50.
Keep these assumptions in mind
Like last weeks butterfly, the example above assumes were still bullish on DRYS. (This Christmas tree is
actually a little less bullish than the standard one set up last week; Christmas-tree holders want the stock to
go to 90 instead of 95, which is what the standard b-fly holders are rooting for.)
You should also keep your expectation realistic: the ONLY time a butterfly is usually close to the maximum
payout is if the stock is right at the middle strike (90) upon expiration. If it makes the move back to 90
tomorrow the butterfly will not be close to worth 10 points. My post on long butterfly spreadswill give you
some good background as to why this is true.
In summary
In a nutshell, here are the key differences between a standard butterfly and a Christmas tree as a repair on
a long call gone awry:
1)
Christmas tree brings in less initial credit than a standard b-fly which means more risk overall
2)
Christmas trees offer a wider sweet spot or break-even points for the new position
3)
Christmas trees also offer more upside than a standard b-fly, if the stock expires at the middle strike
Next week if we are bearish I will give you a trade to consider using a skip strike
on long butterfly spreads will give you some good background as to why this is true.
In summary
In a nutshell, here are the key differences between a standard butterfly and a skip-strike as a repair on a
long call gone awry:
1) Skip-strikes bring in more credit than a standard b-fly, but they require additional margin to be able to
place the trade.
2) Skip-strikes offer a wider sweet spot or break-even points for the new position.
3) Skip-strikes also offer more upside than a standard b-fly, if the stock expires at the middle strike
This ends my series on repairing a wayward long call. The entire series assumes we just have a one contract
long call to start. I should also mention: with one contract to leg into these butterflies the commission costs
start to add up. These trade might make more since for someone with a larger position to start with, at least
on a commission basis.
Standard BF :
1--x--2--x--1
-- Neutral
-- Bullish