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Choosing the "Right" Strategy: The Butterfly Spread (Advanced)

By Andrew Neyens, Optionetics.com | Fri February 14, 2003 2:00PM PT


In the previous installment of this series, we explored the uses of the Butterfly Spread as a technique for profiting from a stagnant stock (see Choosing the “Right” Strategy – The Butterfly Spread, 1/31/03).  The standard Butterfly consists of three legs, the shorting (or selling) of two At-The-Money [ATM] options and the purchasing of one option In-The-Money [ITM] and the purchase of another option that is Out-of-The-Money [OTM] for protection of our two short positions. The distance between the OTM and the ATM options and the distance between the ITM and the ATM options will be the same, generally one or two strikes.  This resulted in a low-cost trade whose risk graph looks like that in Figure 1.    

         

                                                                                                                       
Figure 1: Risk graph of a long Butterfly Spread.

Key to Figure 1

A. Maximum profit of the trade (at expiration).  It is calculated by taking the difference between the long and the short options and subtracting the net debit required to enter the trade.  This number is then multiplied by 100 (number of shares per contract) and then multiplied again by the number of Butterfly Spreads purchased.

B. Maximum loss of the trade (at expiration).  It is the total debit at which we enter the trade.  The calculation is simply the net debit of the bull side of the trade less the net credit of the bear side of the trade.  Another way of calculating the net debit of the trade (and hence maximum loss on the trade) is to sum the two long option’s premium and subtract the double premium that you would receive by selling the two ATM options.

C. The stock price at which the maximum loss will occur as the stock price declines.  This is the strike price of the lower option that was purchased.

D. Lower Breakeven point.  This is simply the lower strike price plus the net debit of the trade.

E. The stock price at which the maximum profit will occur.  This is the strike price of the two options that we sold.

F. The Upper Breakeven point.  This is the upper strike we sold less the net debit of the trade.

G. The stock price at which the maximum loss will occur as the stock price rises.  This is the strike price of the higher option that was purchased.

As we saw, this works quite well with a stock that is not moving, that is stagnant.  However, what if we are looking at a stock that we believe will move?  If the Butterfly Spread is our strategy of choice, could we possibly use it on a stock that we believe will move?

Of course.

What we will do is simply shift the Butterfly up or down, depending on our view of the ultimate movement of the underlying stock.  For instance, let’s look at Ebay, Inc. (EBAY).  As can be readily seen from the price chart (Figure 2), EBAY appears to be in a significant uptrend, and, if our further investigation (fundamental analysis, technical analysis, Ouija board, whatever) confirms our initial read, we should be looking for a bullish trade.  


 Figure 2: A price and volume chart of EBAY.

A bullish Butterfly Spread on EBAY is relatively easy to construct.  Simply sell two options at the strike you believe the stock will move to by expiration, and then purchase one option below that strike and one option above that strike.  With EBAY trading at about $73 today, and estimating that it could climb to roughly $80 by March expiration, we would sell two Calls with an $80 strike and then purchase one Call with a $75 strike and another Call with an $85 strike.  The total debit for this trade will be $1.30 per share, or $130 per spread.  The breakeven on this lower side of the trade will be $76.30 (the lower strike [75] plus the debit [1.30] = 76.30) and the breakeven on the upper side will be $83.70 (the upper strike [85] less the debit [1.30] = 83.70).  The maximum potential profit on this trade will be $370 per spread (the differential between the strikes [5] times 100 shares less the debit for the spread [130] = 370).  This equates to a maximum 285% return on our risk (370/130 = 2.85).

The risk graph of this trade is depicted in Figure 3.  


Note: the risk graph is depicted in the “Modern” style of the Platinum Site of Optionetics.com to better show the relationship between the historical stock price and the profit range of the risk curve.  Rotating the risk graph 900 does not change the results at all.


 
Figure 3: EBAY bullish Butterfly Spread buying 1x 03 March 85 Call, selling 2x 03 March 80 Calls and buying 1x 03 March 75 Call for a debit of $1.30.

The same risk graph could have been produced using Puts instead of Calls, as we learned in the last column.  By purchasing one 03 March 85 Put, selling two 03 March 80 Puts and buying one 03 March 75 Put, we would have had the exact same risk graph as we see in Figure 3.  However, because of the particular pricing of the options on this day, this would have resulted in a total debit of $1.80 instead of the $1.30 debit using Calls, and hence the maximum potential reward would have dropped from 285% to “only” 178% for the 36-day trade.

This trade works well if we are bullish on EBAY, and, in fact, EBAY’s stock price moves up.  However, looking at the same price chart (Figure 2), we might actually be bearish!  How can that be?  One of the basic rules of thumb in the trading business is that after a significant run-up, the stock will generally take a rest and retrace 40-60% of its gains before starting on another move up.  Looking at this chart, if we believe that it has in fact turned over (the stock has actually lost almost $3 from its peak price in late January, we might be looking at a retracement of around 50%.  In its last run up, it went from about $50 per share to just over $75 per share, or a $25 run.  Fifty percent of that is $12.50, or we could be looking at a potential retracement to around $65 per share.  If this was our view (after, of course, checking our fundamental analysis, technical analysis, psychic reader, etc.), then we might choose to put a bearish Butterfly on this stock.  A bearish trade would consist of selling two options at where we estimated the stock would fall, and then purchasing one option above and one option below that strike.

Looking at EBAY, and predicting a retracement to $65, we would buy one 03 March 70 Put, sell two 03 March 65 Puts and purchase one 03 March 60 Put, which, at today’s prices, would be an entry debit of $1.10 per share or $110 per spread.  This results in a breakeven range from $68.90 on the upside to $61.10 on the lower side and a maximum potential profit of 355% if EBAY closed exactly at $65 on Friday, March 21, 2003.  The risk graph is shown in Figure 4.


 
Figure 4: EBAY bearish Butterfly Spread buying 1x 03 March 70 Put, selling 2x 03 March 65 Puts and buying 1x 03 March 60 Put for a debit of $1.10.

As with the bullish Butterfly Spread described above, the bearish Butterfly Spread can be constructed with either Puts or Calls.  Puts were chosen in this case because the pricing of the options is such that an identical Call Butterfly Spread would actually require a debit of $120 per spread.  This narrows the band of profitability by a total of 20 cents (68.80 to 61.20 in the case of the Calls) and reduces the potential profit from 355% to 317%.  It is obviously not a large difference, but why not give yourself every edge you have available.  However, if you were uncomfortable using Puts, you could use Calls in this instance and not penalize yourself too much.

What have we done with this trade?  We have taken the Butterfly Spread, designed for a non-moving stock, and devised both a bullish and a bearish variation of the trade.  Depending on our view of the market, this trade can be made to fit the scenario.  

Is this the best trade for the situation?  If you thought that EBAY might really take off and blow way past the $80 target by mid March, then possibly you would want to enter a Bull Call Spread.  The 75/80 Bull Call Spread for March (buying one 03 March 75 Call and selling one 03 March 80 Call) would risk $195 per spread (as opposed to $130 with the Butterfly) and would have a maximum yield of 156% for anything over an $80 close on EBAY.  The breakeven on the Bull Call Spread would be $76.95 instead of $76.30.  Obviously, you are trading a little more risk, a slightly higher breakeven and a lower maximum potential return if the stock ends up where you expect it to be ($80), for a better return if the stock rockets past your target.  This is a judgement call, but be aware that stocks cannot realistically go to infinity in only 36 days (the length of this trade).  

Another possibility with the Butterfly Spread is to look at it on a long-term basis, using LEAPS instead of the near-term options.  Inspecting a five-year price chart of EBAY (Figure 5), EBAY looks to be heading back for an $80 per share price.


 
Figure 5: A five-year price and volume chart of EBAY.

Over the past five years, an $80 number doesn’t look too bad.  Thus, if we were to enter an 04 January 60/80/100 Butterfly Spread on EBAY, we would probably have the range covered, with a good chance that EBAY would end up somewhere near our $80 estimate.  The spread would cost a little over $500 with a potential profit of almost $1,500 – almost a 300% profit potential.  Thus, if we were bullish on EBAY over the next 11 months, here is a Butterfly trade that could return us almost $3 for every $1 we risk, with a profit range running from $65 all the way up to $95.  The risk graph for this trade is shown in Figure 6.


 
Figure 6: EBAY bullish Butterfly Spread using LEAPS, buying 1x 04 January 100 Call, selling 2x 04 January 80 Call and buying 1x 04 January 60 Call for a debit of $5.10.

While the bullish LEAPS trade may, at first glance, appear to be breaking many of the rules, the smart-aleck answer is that advanced traders can break the rules.  However, a closer examination will show that you are creating a trade in which you can be right over a large price range (a $30 profit range in the case of the 04 January 60/80/100 Butterfly), have a respectable potential return (300%), have eleven months for the trade to work and limit your downside risk.

Exit Criteria

The Exit Criteria for the bullish and bearish Butterfly Spreads are the same as for the standard spreads detailed in the earlier article.  You must either wait until expiration for the Butterfly to mature, or, if there has been a sharp, quick move into your spread (or you have changed your outlook on the stock), you can exit early.  You must simply undo what you did to enter the trade – buy back your two short positions and sell your two long positions.

Conclusion

The Butterfly Spread (be it Puts or Calls) is an extremely flexible and efficient trade.  As most stocks are treading water, this strategy will tend to fit most stocks if you enter an ATM Butterfly (sell the body using ATM options and purchase one option ITM and one option OTM for protection on the wings).  However, if you have reason to believe that the stock might move decisively one direction or the other, you can also use the Butterfly to trade that movement.  However, it was not really designed to be used as a directional trade, so if you choose to use it as such, you will find that it will take somewhat more work to be sure that the trade does not get away from you.  You will have to monitor the trade more carefully, and be ready to exit at the first sign that the trade might be going bad – either the stock not moving into your target range, or the stock blowing right past your target range.

Of course, to use the Butterfly Spread trade as either a bullish or bearish strategy, you will need options available that fit your scenario.  For instance, in the EBAY trade discussed in this article, if our belief was that the stock would go to, or even above, $100 by January, 2004, then we would need 04 January options that were above $100 for our upper leg (and maybe even our body).  As EBAY has no options available at this time above $100, we would not be able to enter a Butterfly Spread to match our expectations.

The two basic problems with the Butterfly Spread – commission intensive and limited profitability on both the upside and downside of the stock price – have not changed with the advanced uses of the spread.  You have to be cognizant of these limitations and work with them.  However, the profit potential and the peace of mind from the large profit range that is inherent in this style of trading can be well worth the extra work that will be required.  

Good Trading.


Andrew Neyens
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Educations Site
aneyens@optionetics.com

 

 

 



Recent articles by Andrew Neyens, Optionetics.com


December 01, 2010  -  Closing Wrap-Up, December 1
November 24, 2010  -  Real-World Trading: Learning to Profit from a Broken Wing Butterfly, Part IX
September 29, 2010  -  Fundamental Focus: An Uncertain Time for the Market?
May 20, 2010  -  Closing Wrap-Up, May 20
December 14, 2009  -  Growth Stock Swing Option: Dec 14, 2009


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