The Ultimate Options Course Butterfly Spreads

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Millicent Hart
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2 Disclosures and Disclaimers Buying and selling stocks and opaons involves risks and may not be suitable for all investors. Prior to buying or selling an opaon, the investor must receive a copy of the booklet, CharacterisAcs and Risks of Standardized OpAons, from your broker or from The OpAons Clearing CorporaAon, 1 North Wacker Drive, Suite 500, Chicago, IL The informaaon in this presentaaon is presented for educaaonal purposes only. It should not be construed as a recommendaaon or solicitaaon to buy or sell opaons. Many examples of opaons trades are presented in this presentaaon as illustraaons of the principles being taught in this course. These examples are not recommendaaons or solicitaaons to buy or sell any stock or opaon. To simplify the calculaaons, commission costs have not been included in the examples in this presentaaon. Commission costs will affect the outcome of any stock or opaons trade and must be considered prior to entering the transacaon. No representaaon is being made that any account will or is likely to achieve profits or losses similar to those discussed in this presentaaon. The past performance of any trading system or methodology is not necessarily indicaave of future results. 2

3 Introduction Create the ATM buserfly spread: 1) Sell two calls ATM 2) Move up one strike and buy one call OTM 3) Move down one strike and buy one call ITM The opaons sold ATM are called the body of the buserfly and the opaons purchased OTM and ITM are the wings BuSerfly spreads may be created with calls or puts; we can vary the width of the wings The buserfly spread is two veracal spreads sharing the short strike price BuSerfly spreads are usually debit spreads 3

4 The Basic Butterfly Spread A call buserfly on GOOG at $518 on 5/16/11: Buy 1 Jun $570 call at $0.88 Sell 2 Jun $520 calls at $12.30 Buy 1 Jun $470 call at $49.45 Debit = $2,573, BE = $496 and $544, maximum profit = $2,427, maximum loss = $2,573 A put buserfly on GOOG at $518 on 5/16/11: Buy 1 Jun $570 put at $52.70 Sell 2 Jun $520 puts at $14.05 Buy 1 Jun $470 put at $2.03 Debit = $2,663, BE = $497 and $543, maximum profit = $2,337, maximum loss = $2,663 Use calls or puts, whichever is cheaper, but they are usually close No margin requirements as long as wings are equidistant NoAce the favorable risk/reward raaos 4

the wings, the breakevens will broaden, but the debit will also increase.

5 GOOG 470/520/570 Call Butterfly Spread This is a much more reasonable esamate of profit Note the more favorable risk/reward raao As I broaden the wings, the breakevens will broaden, but the debit will also increase. Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 5

6 Finding Candidates Look for stocks you expect to trade within a channel for the next 30 days Use opaons with about 30 days to expiraaon Broadened wings: Widen the BE range Increase the cost Decrease the return ATM buserflies are negaave vega posiaons, i.e., increasing IV hurts the trade profit/loss posiaon Changes in IV do not affect the ulamate profitability of a veracal spread IV changes do affect the risk/reward curves increased IV makes it difficult to exit early Because the BE range is narrow for the buserfly, one should exit the trade with increasing IV Some place buserflies on stocks just before an earnings announcement 6

7 Margin Requirements The margin requirements for call buserflies and put buserflies are zero Pulling the two sold strikes apart creates a margin requirement Making one wing larger than the other creates a margin requirement (a broken wing buserfly) When closing buserflies, a margin requirement may kick in if closing the debit side first The margin requirement for the iron buserfly is based on the wing spread Brokers have considerable discreaon when establishing margin requirements. Always check for your broker s specific requirements. 7

8 General Guidelines for Managing the Trade Establish the buserfly spread one veracal spread at a Ame or enter the trade as a single order Close the buserfly spread if the loss exceeds 20% Close at least a poraon of the posiaon if a profit of 25% is available The maximum profit is very unrealisac Close the buserfly on the Friday before expiraaon Close the buserfly one veracal spread at a Ame 8

9 The Iron Butterfly An iron buserfly is formed by a bear call spread and a bull put spread with the short opaons at the same strike price An iron buserfly on NFLX at $237 on 5/16/11: Buy 1 Jun $270 call at $1.83 Sell 1 Jun $235 call at $12.10 Sell 1 Jun $235 put at $9.98 Buy 1 Jun $200 put at $1.58 Credit = $1,867, BE = $216 and $254, maximum profit = $1,867, maximum loss = $1663 The iron buserfly has similar margin requirements to the iron condor ($3500 above) The iron buserfly is similar to an iron condor but with a smaller BE range and a beser risk/reward raao If the stock/index price is in between strike prices, move the short strikes to either side 9

10 The Iron Butterfly NFLX Jun 200/235/270 Iron Butterfly The original credit is not a reasonable profit target The iron buserfly is similar in every respect to the debit buserfly except it has a margin requirement Closing a week before expiraaon is a reasonable profit target 10

11 Butterfly Spreads Cover A Lot Of Territory Regular call or put debit butterfly The Iron Butterfly OTM Butterfly Spreads Butterflies as Adjustments Butterflies as Hedges The Broken Wing Butterfly ATM Butterfly Spreads For Income 2011 Parkwood Capital, LLC. All Rights Reserved. 11

Butterflies and Condors Are Cousins +10 cts 900 calls +10 cts 900 calls 10 cts 890 calls RUT = 820 20 cts 820

12 Butterflies and Condors Are Cousins +10 cts 900 calls +10 cts 900 calls 10 cts 890 calls RUT = cts 820 calls 10 cts 750 calls +10 cts 740 calls +10 cts 740 calls Risk/Reward RaAo Decreasing BE Range Decreasing 12

13 OTM Butterfly Spreads As a bullish speculaave trade, place an OTM buserfly above the current stock or index price As a bearish speculaave trade, place an OTM buserfly below the current stock or index price These trades can be established for a small investment, but they are speculaave, high risk trades Some traders use an OTM buserfly as insurance for the expected move (the what if I m wrong trade) 13

OTM Butterfly Spreads 3/7/07 GOOG Jan 08 500/550/600 An example from my 2007 porsolio Note the wide BE range

14 OTM Butterfly Spreads 3/7/07 GOOG Jan /550/600 An example from my 2007 porsolio Note the wide BE range Closed in the fall for a gain of 125% Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 14

OTM Butterfly Spreads 6/18/10 AAPL Jan 11 270/300/330 An example from Dr.

15 OTM Butterfly Spreads 6/18/10 AAPL Jan /300/330 An example from Dr. Duke s Trading Group Closed 10/18/10 for a gain of 51% Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 15

16 The Butterfly as an Adjustment 8/16/07 CME 540/550 Bull Call Spread CME = $530 and has hit support Note long lower shadow on the candle Sept $540/$550 bull call spread for $460 Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 16

17 The Butterfly as an Adjustment 9/4/07 CME 540/550 Bull Call Spread CME = $565 Close for a gain of $265 (56%) Or create a buserfly Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 17

18 The Butterfly as an Adjustment 9/4/07 CME 540/550/560 Butterfly CME = $565 Sold the 550/560 bear call spread Min gain = $180 (39%) Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 18

19 The Broken Wing Butterfly This strategy is very popular recently and is probably over hyped The broken wing buserfly is also known as the skip strike buserfly Established by skipping one or more strikes on one of the wings May be a credit or a debit We now have a bias toward one price direcaon of the underlying stock or index Skip the strike price on the side opposite where you think the move may occur Disadvantages: 1) a margin requirement and 2) increased risk/reward raao The maximum loss for a broken wing buserfly the iniaal debit 19

20 The Broken Wing Butterfly 8/20/07 GOOG 480/500/510 Broken Wing Butterfly GOOG = $498; debit = $835 The trader believes GOOG has bounced Profitable for any price > $488 Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 20

The Broken Wing Butterfly 8/31/07 GOOG 480/500/510 Broken Wing Butterfly GOOG = $515 Can close

22 The ATM Butterfly For Income Simple Trade Management Approach 1. Establish the spread around 30 days to expiraaon; fill one veracal spread at a Ame 2. Compare calls and puts to see which give you the best prices and returns 3. Sell the ATM opaons and buy at one σ OTM and one σ ITM If using an iron buserfly, buy both opaons at one σ OTM 4. Be sure the wings are equidistant to establish a zero margin requirement The iron buserfly always has a margin requirement 5. Buy extra calls and/or puts to make the trade delta neutral 6. Close the trade when you are down 20% 7. Close the trade and take your profit if you are up 25% 8. Close the trade on the Friday before expiraaon week 22

23 The ATM Butterfly For Income Advanced Trade Management Approach 1. Establish the spread around 30 days to expiraaon; fill one veracal spread at a Ame 2. Compare calls and puts to see which give you the best prices and returns 3. Sell the ATM opaons and buy at one σ OTM and one σ ITM If using an iron buserfly, buy both opaons one σ OTM 4. Be sure the wings are equidistant to establish a zero margin requirement The iron buserfly always has a margin requirement 5. Buy extra calls and/or puts to make the trade delta neutral 6. Close the trade when you are down 20% 7. Close the trade on the Friday before expiraaon week 8. If the stock or index price hits either BE, adjust the trade: Cut posiaon delta in half by rolling the appropriate number of spreads up or down 23

ATM Butterfly Adjustments (1) 11/16/09 RUT Dec 560/600/640 Call Butterfly

25 ATM Butterfly Adjustments (1) 11/30/09 RUT Dec 560/600/640 Call Butterfly PosiAon Δ = $208 and θ = +$192 Near lower BE for adjustment Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 25

26 Ayer closing five 600/640 spreads and opening five 540/580 spreads PosiAon Δ = $167 and θ = +$297 ATM Butterfly Adjustments (1) 11/30/09 RUT Dec 560/600/640 Call Butterfly The new 540/580 spreads are broadening the R/R curves Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 26

27 Ayer closing ten 600/640 spreads and opening ten 540/580 spreads PosiAon Δ = $49 and θ = +$177 ATM Butterfly Adjustments (1) 11/30/09 RUT Dec 560/600/640 Call Butterfly The new 540/580 spreads are broadening the R/R curves Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 27

ATM Butterfly Adjustments (2) 1/12/10 RUT 610/640/670 Call Butterfly

ATM Butterfly Adjustments (2) 1/19/10 RUT 610/640/670 Call Butterfly

ATM Butterfly Adjustments (2) 1/22/10 RUT 610/640/670 Call Butterfly Hit lower BE Need

31 ATM Butterfly Adjustments (2) 1/25/10 RUT 610/640/670 Call Butterfly Closed five 610/640 call spreads Reduced downside risk Bought some Ame Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 31

32 ATM Butterfly Adjustments (2) 1/27/10 RUT 610/640/670 Call Butterfly Closed for $1,480 gain or 18% in 16 days Without adjustment, would have lost $650 Screenshots provided courtesy of OpAoneAcs PlaAnum, 2011 all rights reserved 32

33 Conclusions BuSerfly spreads have the advantages of a relaavely small investment and a favorable risk/reward raao Broadening the wings will result in a larger profit window, but will also increase the iniaal debit ATM buserfly spreads may be used as non direcaonal income trades OTM buserfly spreads are more speculaave direcaonal trades Consider the buserfly spread as an adjustment to lock in gains and/or hedge a posiaon The broken wing buserfly is an advanced buserfly strategy with a direcaonal bias; the margin requirement and increased risk/reward raao are the principal disadvantages 33

34 Homework 1. On 1/28/09, GOOG closed at $ A trader is considering the following spreads: a) Jan /450/500 call buserfly b) Mar 330/350/370 call buserfly c) Mar 300/320/340 put buserfly 3. What would you infer was the trader s expectaaon for GOOG if he were to establish each of these trades? 4. Based on the opaon chain on the following slide, compute the iniaal credit or debit, and the margin requirement for each of the following RUT spreads: a) Jan 570/600/630 call buserfly b) Jan 570/600/630 iron buserfly c) Jan 570/600/630 put buserfly d) Jan 550/600/620 call buserfly 5. What is the Jan 550/600/620 call buserfly called? What would be your price predicaon if you established this spread? 34

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The Ultimate Options Course Double Calendar Spreads

The Ultimate Options Course Double Calendar Spreads Kerry W. Given, Ph.D. (Dr. Duke) Parkwood Capital, LLC 2011 Parkwood Capital, LLC. All Rights Reserved. Disclosures and Disclaimers Buying and selling