REAL-WORLD TRADING: Neutral Trading with an Iron Butterfly, Part III
January 30, 2003
During the past two weeks we have been discussing the details of an Iron Butterfly trade. Last week, we chose biotech firm Amgen (AMGN) as a stock to use to follow a mock trade using this strategy. Before we go into the details of how the trade fared last week, let’s review what an iron butterfly is and how we find these trades.
An iron butterfly has a risk curve exactly like a condor. However, a condor is a debit strategy, whereas an iron butterfly is a credit strategy. An iron butterfly uses both calls and puts, which in essence is the combination of a bull put spread and bear call spread. If we expect a stock to close between the sold options, then we would receive the max reward. We need do nothing to collect this profit, as we would just keep the credit received, letting the other options expire worthless. In general, it is best to use high IV options, as a drop in IV increases the value of the trade. However, in most cases we plan on holding until expiration, so IV won’t matter. Figure 1, below is a graph of how the trade would fare based on a change in IV.
Figure 1: Implied Volatility, AMGN
What this graph shows is how the trade would move based solely on a change in IV, with the stock staying at the same price. Notice how a large drop in IV would benefit the trade, whereas; a large rise in IV would be a detriment. However, the changes are minor in comparison to the overall profit, even with a sharp move in IV.
During the past week, AMGN has moved slightly higher, leaving our trade near the flatline. However, after an initial spike after earnings, AMGN has fallen back down, leaving our trade in good condition. Many might be wondering what exit strategies should be used for this trade. This is a personal decision, but I like to set an exit price based on reward to risk. For example, traders might want to exit if half the possible reward is lost. So, if $1,200 is our max reward, we might want to get out if the trade is down $600. This trade would have gotten close to this exit price on the 23rd of January when AMGN spiked after earnings, but it never would have reached this loss amount. Below is the data for this mock 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)
Don’t be confused about the breakeven prices, as this are based on expiration. The breakeven and profit zones before expiration can be seen by viewing the risk graph below (Figure 2):
Figure 2: Risk Graph, AMGN
Looking forward, there are a few things we should be aware of. First, in the past few months, the stock has formed an ascending trendline. This line is coming into play at current levels for AMGN, so we need to keep an eye on this. Second, the overall market is in a downtrend, despite Tuesday’s gain in price. In a downturn, most stocks fall, making it likely that AMGN will continue to move lower in the following weeks.
The fact that we use front-month options is also an advantage in my eyes. This is because we have a better chance predicting where a stock might be when expiration is just weeks away, instead of months. Overall, I like the set up of this trade, even though the stock has been in an uptrend the last two months. We expected resistance near $53 to hold and though AMGN moved through it on the 23rd, it quickly moved back below this level.
We will continue to track this mock trade until option expiration, so feel free to ask any questions or make any comments you have about this strategy or article on my forum.
Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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