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This week I would like to make mention of a potentially exciting new tool available to option traders. John Broussard and Ray Vos – the brains behind Optionetics Platinum software - recently moved an interesting tool over from the futures version of Platinum into Platinum Pro. It is referred to in the program as the "OTM Butterfly Finder." Now I realize that I am placing myself squarely in the “option geek” realm to come right out and refer to something titled the “OTM Butterfly Finder” as “exciting." But I stand by that statement. Okay, so what the heck does OTM Butterfly Finder mean? Technically it stands for “out-of-the-money butterfly finder." What it represents is an opportunity to search for multitude of low-risk, high-reward trades that you probably never knew existed. So let’s take a closer look.

First off, let me state that there are more possibilities than I can cover here. So the idea here will simply be to give you a “taste” and those who catch the spark can dig more deeply on their own. Chart 1 displays the input screen for this routine. Now I realize that a lot of individuals – particularly those new to option trading – will immediately feel a bolt of fear go through them as they try to absorb all of the myriad inputs displayed on this screen. Please try to fight that initial reaction and bear with me a little longer here.

Chart 1 – OTM Butterfly Finder
(click here for larger view)

In a nutshell, this routine is looking for out-of-the-money butterflies of various shapes and sizes. For example, some of the choices that a trader can make include:

1. How far out-of-the-money the middle option should be.
2. The width between the strikes and whether there will be the same distance between the first option bought and the option sold as there is between the second option bough and the option sold (if not, this is referred to as a “broken wing butterfly”).
3. The length of time until expiration (choices are <45, 45 to 180, 180 or more).
4. Whether the trade will be done in the classic 1-2-1 ratio (for example, buy 1 call, sell 2 higher strike calls and buy 1 more higher strike call), or something different (for example, buy 2 calls, sell 3 higher strike calls and buy 1 more higher strike call).

These possibilities capture perfectly one of the tradeoffs that all option traders face – more possibilities equals more complexity. And each trader has to choose how complex is “too complex” for them, at the same time attempting not to limit their own potential.

Looking at the Stock Indexes

Let’s look at some possibilities using a list of stock indexes upon which options are traded. Using the basic default settings on 7/16/08 we find the following trade using mini Nasdaq 100 (MNX) options at the top of the list.

Chart 2 – MNX out-of-the-money butterfly

The risk curves for this trade appear in Chart 3.

Chart 3 – MNX risk curves

As you can see in Chart 3, what we have is a standard butterfly spread, however, instead of having the peak profit area centered around the current market price, the whole set of risk curves is moved “up” in price.

Now it is impossible to say if this is a “god trade” or a “bad trade”, because it depends on but we can make a few reasonable assessments of the relative pros and cons. The good new is that this trade has a maximum risk of only $236. Likewise, it has a profit range of about 30 points (197 to 227). If MNX rallies immediately the potential to take an early profit or to adjust the trade into a different position is great. The bad news is that this trade will suffer a lot of time decay during the last 20 days prior to expiration, and the breakeven point at expiration is about 16 point, or 8.8% above the present level. So clearly a trader must be pretty bullish to consider this trade.

Mixing Things Up

Now let''s look at another twist. For this test, we will keep all of the settings the same except for the buy/sell ratio and the time until expiration. For this test, instead of using 1-2-1 ratio, we will specify a ratio of buy 2, sell 3 and buy 1. Also, we will specify that the options traded must have between 45 and 180 days left until they expire. The top trade this time involved the use of DIA options as shown in Chart 4.  

Chart 4 – SPY 2-3-1 Out-of-the-money butterfly

Chart 5 displays the risk curves for this position. As you can see, we are now getting a bit “off the beaten path” from your typical “buy a call” or “buy a put” positions.

Chart 5 - Risk Curves for SPY OTM Butterfly

Once again, the key to properly assessing this trade is to consider what has to happen in order to profit and where the risks lay.

• If SPY starts to rally this trade will start to make money immediately.
• If SPY fails to rally, this trade holds a maximum risk of $399.
• SPY is at 126.16 with 88 days left until option expiration. With a breakeven price of 134.99, SPY would need to rally at least 7% by the time of expiration for this trade to show a profit.
• Given the amount of time decay that occurs in the last 30 days prior to expiration, a trader might consider taking an early profit if the opportunity arises.

Summary

In the end there is nothing inherently better or worse about the trades that the new OTM Butterfly Finder can help you to spot. Each potential trade has to be judged on its own merits based on your own outlook an ability to tolerate risk. But one thing I can assure you is that in this routine you will find some very unique opportunities that you have likely not considered before.

It looks to me like the “boys in the lab” have done it again.

To search for previous articles written by Jay Kaeppel, please click here.

Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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Recent Articles by Jay Kaeppel, Optionetics.com

• September 3, 2008
  Kaeppel’s Corner: Take That, Father Time!
• August 27, 2008
  Kaeppel’s Corner: When Sideways Is Swell
• August 27, 2008
  Outside the Box: The Strengths and Weaknesses of Automated Trading Systems
• August 20, 2008
  Kaeppel’s Corner: When Up Is a Downer
• August 13, 2008
  Kaeppel’s Corner: A New Tool—The OTM Butterfly Finder