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REAL-WORLD TRADING: Neutral Trading with an Iron Butterfly, Part V

By Jody Osborne, Optionetics.com | Wed February 12, 2003 7:30AM PT


During the past five weeks, we have been discussing the details of an iron butterfly trade. In order to show how this strategy works, we chose a stock to enter a mock trade on. The stock we chose was Amgen (AMGN). The reason we chose Amgen was because it was running into resistance and we felt that the overall market would take the stock down into a trading range. So far, Amgen shares have held up rather well, creating a paper loss for our iron butterfly at present. Below is a risk graph of this trade through Tuesday, February 11, 2003.

 

Notice how the current price of the stock is below our breakeven point. This means that if the stock closes at its current price at expiration, we would lose money. Below is the week-to-week data for this trade, with this week’s data showing the current status of the trade.

Jan. 21, 2003
AMGN Iron Butterfly
Stock Price: $51.59
Buy 5 Feb 40 Puts @ 0.2 = -$100
Sell 5 Feb 45 Puts @ 0.55 = $275
Sell 5 Feb 50 Calls @ 2.60 = $1300
Buy 5 Feb 55 Calls @ 0.55 = -$275
Total Credit = $1200
Max Risk = $1300
Downside Breakeven = 42.60
Upside Breakeven = 52.40

Jan. 28, 2003
AMGN Iron Butterfly
Stock Price: $50.87
5 Feb 40 Puts @ 0.10 = $50
5 Feb 45 Puts @ 0.35 = -$175
5 Feb 50 Calls @ 2.75 = -$1375
5 Feb 55 Calls @ 0.50 = $250
Total Credit = $1,200
Cost to Close Trade = $1,250
Current Loss = $50 (not including commissions
Max Risk = $1300
Downside Breakeven = 42.60 (at expiration)
Upside Breakeven = 52.40 (at expiration)

Feb. 4, 2003
AMGN Iron Butterfly
Stock Price: $51.83
5 Feb 40 Puts @ 0.00 = $0
5 Feb 45 Puts @ 0.20 = -$100
5 Feb 50 Calls @ 2.65 = -$1325
5 Feb 55 Calls @ 0.35 = $175
Total Credit = $1,200
Cost to Close Trade = $1,250
Current Loss = $50 (not including commissions
Max Risk = $1300
Downside Breakeven = 42.60 (at expiration)
Upside Breakeven = 52.40 (at expiration)

Feb. 11, 2003
AMGN Iron Butterfly
Stock Price: $53.45
5 Feb 40 Puts @ 0.00 = $0
5 Feb 45 Puts @ 0.10 = -$50
5 Feb 50 Calls @ 3.70 = -$1850
5 Feb 55 Calls @ 0.50 = $250
Total Credit = $1,200
Cost to Close Trade = $1,650
Current Loss = $450 (not including commissions)
Max Risk = $1300
Downside Breakeven = 42.60 (at expiration)
Upside Breakeven = 52.40 (at expiration)

Despite the fact the stock is outside the profit zone, we could close this trade for about a $450 loss, not counting commissions. If Amgen were to close at $53.45 at expiration, our total loss would be $525. This is found by taking what each option would be worth at expiration. Only the 50 Call would have any value, but its value would be $3.45 or $1,725. We took in a $1,200 credit in the beginning, so our total loss would be $525. The advantage in waiting for expiration is that we wouldn’t have any commissions to account for. However, if we believe the stock is going to continue higher, we would be best served to take our losses now.

We often talk about knowing our exit before we enter. An iron butterfly is no different, though the exit point used will very for different traders. One popular way to figure an exit point is to use a reward-to-risk ratio. For example, if you are only willing to risk half the amount that you can win, then your reward-to-risk ratio is 2-to-1. In our particular trade, this means you would exit the trade when your loss surpasses $600. Our max reward is $1,200, so a 2-to-1 reward to risk ratio equals $600. There isn’t a specific ratio that we should use for this strategy, as it all depends on your normal success ratio and each traders risk tolerance. Since we have a larger profit area when trading this type of strategy, our reward-to-risk ratio doesn’t need to be as high.

A trader might be willing to lose the max amount on each trade because they know over the long haul they will win twice as many trades as they lose. Of course, this is all going to depend on your ability to trade and your risk tolerance. The one negative to closing condors or butterflies out early is the added commission expense. With four legs to each trade, commissions can be large, especially if the total dollar amount traded is small.

My suggestion would be to go back in time, using Platinum, finding stocks that were in channels. Then, enter paper trades on the stocks that fit the appropriate criteria and see what success rate you have. This is a quick and efficient way to paper trade without having to wait weeks or months to find out your success rate. Of course, you have to put yourself in a mindset that you would have had at the time the trade is being investigated. Once you get an idea of your success rate, then you can set an appropriate reward-to-risk ratio for future trades.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

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To search for other articles in this series, please click here.



Recent articles by Jody Osborne, Optionetics.com


December 03, 2010  -  Economic Watchdog, Dec 3
December 03, 2010  -  Closing Wrap-Up, December 3
December 03, 2010  -  Morning Watch, December 3
December 02, 2010  -  Economic Watchdog, Dec 2
December 02, 2010  -  Closing Wrap-Up, December 2


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