In our first installment of “Float like a Butterfly,” (9/28/08), we discussed the make-up of the strategy. This week, we want to go through the steps of choosing a stock to use a butterfly on so that we can track it and see how it works in the real world. Before we do choose a stock, let’s review the butterfly and what sort of stock best fits this strategy.
A butterfly is the combination of three different option strikes, normally equally spaced and usually using either all calls or all puts. The idea is to buy a lower strike, sell two middle strikes and buy a higher strike. The max profit is achieved if the stock closes at the middle strike at option expiration. We showed last week that higher implied volatility does create a higher max profit.
Here are some of the criterion we are looking for when creating a butterfly strategy.
- Stock that we expect to stay in a range or close at a certain strike at expiration
- Stock with options showing above average IV
- Normally want to use front-month option strikes
- Stock that doesn’t have any pending news that could move it sharply in either direction
One way to find high IV stocks is to use the Custom Ranker on Platinum. Once we have a list of stocks showing high IV on its options, we can then run the Find Trades III tool to narrow down possible butterfly trades.
The way to do this is to first run an option ranker for high IV stocks. Once this is done, we can use this list to search for ATM butterflies using Find Trades III. When we run this search, one stock found on this list is Capital One Financial (COF). The trade found looks like this:
COF @ 70.83
Buy 1 Oct07 65 Call @ 6.40
Sell 2 Oct07 70 Call @ 2.45
Buy 1 Oct07 75 Call @ 0.55
The prices above are found by getting into the spread and the risk graph is found below:
Figure 1: Risk Graph of COF Butterfly
Below is the specific data for the trade:
Figure 2: Data on COF Butterfly Trade
This trade only has 9 days left until expiration and has a max profit of $295 with a max risk of $205. The trade will make a profit as long as COF closes between $67.05 and $72.95 at October expiration.
When looking at a trade, we should always have an understanding of the worst case scenario. With this trade, the worst case would be a sharp move in either direction outside of the upper and lower strikes. However, even if this occurs, the maximum loss would be $205 plus commissions for each butterfly entered.
The really nice thing about this particular trade is that the stock only has nine days to move outside the profit zone. Looking at the chart, the stock should find resistance at its current level. Earnings season kicked off this week and this can create volatility. In fact, COF is set to announce earnings on Oct. 18, which is a day before option expiration.
We will update this trade next week and discuss the choices we have heading into the company’s earnings release. If you have any comments or questions, please feel free to put them on my forum so we can discuss them.
To read previous installments of Real-World Trading, please click here.
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