What’s the difference between a Butterfly over 3 consecutive strikes and a Condor over 4 consecutive strikes (including the Butterflies’ 3 strikes)?

Some Advisory Services Love this Strategy, I Don’t:

Sell a Put to Finance the Purchase of a Bull Spread.    

By Charles Cottle

Last week I received the following RDSOS: 

SMH (the popular ETF that tracks Semi-Conductor Stocks) February Options:  A trader thought it would be cool to buy the FEB 27/28 Call Vertical Bull Debit Spread (going for .41 (.90-.49) and finance the purchase by Shorting the FEB 26 Put (going for .46, so he actually received a .05 Credit to pay for commissions).  OK, I got it.  What follows is what the trader and some advisory services don’t get:

Obviously, the trader is bullish and believes or hopes that the wager of .41 will turn into 1.00 for a .59 profit.  Hmm, how does he pay for the .41?  By short selling the 26 put for .46. 

OK, Time Out! 

Quick Lesson:  Understand the game.  How can you win, if you don't know the game?  I suggested to the trader to; “Imagine that you put on a ‘Short Wings’ FEB 26/27/28 Iron Butterfly with the same strikes (as your strikes) and also Sell 10 FEB 27 Puts”

Firstly, you would see that the +10 FEB 27 Puts from the Iron Trade liquidates the -10 FEB 27 Puts on the second trade, leaving the trader with the actual trade that he initially put on (27/28 Call Bull Spread and Short 26 Put).  OK, so?  Well how many traders do you know who would put on a ‘Short-Wings’ Iron at these prices (.83 Debit to make .17 when the Iron goes to 1.00, if SMH is below 26.00 or above 28.00 at expiration)?  Most traders ‘BUY the Wings’ on Irons in order to risk less and make more.

Check out the image below using the New Risk Illustrator:

Legend:

10 ‘Short Wings’ FEB 26/27/28 Iron Butterflies: Green Dashed Line and Highlights.

Short 10 FEB 27 Puts: Red Dashed Line and Highlights.

Long 10 FEB 27/28 Call Bull Spreads & Short 10 FEB 26 Puts: Pink Solid Line and Highlights.

The yellow parallelogram represents the basic difference between 10 FEB 27 Puts, naked short and the 30 options (3-way) initiated by the trader.

Bottom Line: The initial trade is highly inefficient, harder to manage and has 3 times the slippage (bid/ask spreads) and commissions. 

So now what?

The simplest short premium trade to manifest the trader’s slightly bullish opinion would be to sell naked* puts.  Which strike?  How many?

If SMH rallies to $28.00 or higher by expiration, this trade would profit $630 (.17 from the Iron and .46 from the 27 Puts Shorted, 10 each).  Using the put options prices in the third row of the image, it would be more efficient to simply short 14 or 15 FEB 26 Puts (.44 each) for a credit of $616 or $660. 

I wouldn’t sell puts naked*, I would consider shorting 25 or 26 FEB 25/26 Put Credit Spreads that are Limited Risk Short Premium Bullish for a $625 or $650 Credit (receiving .44 for the 26 Puts and paying .19 for the 25 Puts). 

*Caution: There is really no need to sell them naked as a greater quantity of Put Credit Spreads will achieve a similar objective with limited risk.

The ‘Difference’ is the amount that remains after one quantity is subtracted from another. The What’s The Difference? Blog is dedicated to this theme as it applies to options trading.

This week we begin with “What’s the difference between a lower strike straddle and a higher strike straddle?” Try to answer that before continuing.

Here are just a few of the differences (in no particular order) that we will blog about in the future:

What is the difference between a butterfly and a condor?

What is the difference between a butterfly and a broken wing butterfly?

What is the difference between a double diagonal and an iron condor?

What is the difference between a one-month calendar and a two-month calendar?

What is the difference between a put and a covered write?

What is the difference between a debit spread and a credit spread?

What is the difference between a call butterfly and a put butterfly?

Answer to “What’s the difference between a lower strike straddle and a higher strike straddle?” is 2 Bull Spreads (twice as many* bull spreads as straddles). Ok, who cares? Some of you might care if you need an idea of how to roll up a straddle or wish to gamma scalp and not use the underlying. This will help you to understand alternatives available to you when you are in a tight spot.

Explanation: Let’s say that the lower strike straddle is represented by 10 MAR 40 Straddles and the higher strike is represent it by 10 MAR 45 Straddles.

Using the Risk Doctor’s New Risk Illustrator Software, we can see that if we Buy 10 MAR 40 Straddles and Sell 10 MAR 45 Straddles, the result (difference) is 20 (twice as many*) MAR 40/45 Bull Spreads.

Legend: Long 10 MAR 40 Straddles: Green Dashed Line and Highlights. Short 10 MAR 45 Straddles: Red Dashed Line and Highlights. Bull Spread: Pink Solid Line and Highlights.

*More details on this subject in Chapter 5 of “Options Trading: The Hidden Reality”.

By Charles Cottle

Friday, December 18^th, I received an RDSOS (not from Sting):

SPY (the popular ETF that tracks the S&P 500) 'Quarterly', DEC31 options expire on the last day of 2009, December 31st.  A trader, unaware that there was a Dividend on December 18th was assigned on some short calls when the SPY was trading about 109.50.  He was assigned on most of his short 'Body' Calls of his Long ITM 104/105/106 Call Butterfly (+15by-30by+15) originally bought for less than .10 or $150 (15 x .10 x 1oo shares).  Only mistakenly do Stock and ETF Calls get Early Exercised, because it is a beneficial cost savings not to exercise, since more capital would be required for taking delivery of the stock.

However, when there is a Dividend* that has a greater value than any OTM put, the corresponding call becomes a candidate for early exercise.  I say candidate but there are good reasons not to explained in Chapter 3 of my book

When I was phoned, it was after the anxious trader hastily bought back 5oo of the 25oo (5 short DEC 105 Calls remained) short shares acquired.  BIG MISTAKE! Actually, using 20/20 hind-sight, buying back all the shares would have profited handsomely, with only minor sweating along the way because the SPY rallied to over 111 by expiration.  Even so, why was it a mistake?

It goes back to the original purpose of the trade and the approach and risk/reward threshold for the trade.  This trader initiated a limited risk butterfly position, risking under $150.  The trade morphed via assignment (trader not aware of and unprepared to pay a dividend).  This added limited risk in the amount $1475 (.5902 on 25oo shares -- the dividend pay-out).  The subsequent trade of 5oo shares added almost $2500 and would have added another $10,000, if the trader had covered (bought back) the remaining 20oo shares created from the assignment.   OK, Time Out!  Let's work it all out.

Quick Lesson:  Understand the game.  How can you win, if you don't know the game?  The most important aspect of my work is showing people how to look at positions a little differently.  It's not rocket science but you are required to use imagination.  Since positions can be dissected in order to better inform a trader, I am going to ask you to try to understand something perhaps different than you have done before.  I suggested to the trader to imagine that he was long and short (at the same time) 25 DEC31 Calls.  That is +25 and -25.  No position right? Flat, right?  Then, I said, "use the -25 for the purpose of reestablishing your butterfly (+15by-30by+15), the -30 is comprised of the imaginary -25 plus the remaining, unassigned, real -5 DEC31 105 Calls".

"Now, take the imaginary +25 and pair it off against the -25oo shares".  What is that, then?  Answer: +25 synthetic DEC31105 Puts going for about .40 (shy of the .59 added cost due to paying the dividend).

Bottom Line: The position still has limited risk and will, subsequent to assignment, behave like the original butterfly 1x30x15 PLUS 25 long cheap-out-of-the money puts. 

So now what?

It seems that the trader could simply trade 25 DEC31 105 Covered Writes (Buy 2500 shares / Sell 25 DEC31 105 Calls) to reestablish the position to the way it was before the assignment. Certainly if the market dropped a bit and he got filled on the call with an extrinsic premium of .59 then he would have recouped the potential loss for paying the dividend.  However, there is one potentially costly pitfall - when a call is well into-the-money, it will often trade with a wide bid/ask spread that is a rip-off to trade. 

The easiest trade to salvage what is available would be to simply Sell the 25 DEC31105 Puts (whether taking loss or not).  All positions would go away at expiration (above 106) through the exercise process.  Caution: There would be the chance for Pin-Risk at expiry if SPY is trading exactly at 104, 105 or 106 to deal with.  That is a conversation for another Blog post.

Epilogue: You might like to know that our SOS hero, by his own choice, sold 25 various higher strike puts, creating synthetic bull spreads with the understanding that the lower strike synthetic 105 puts protected his downside.

* Actually it is the amount of the Dividend less the cost of carrying the stock – under .04 per share for the remaining period until expiration in this case (Strike of 105 x 13 Days Left, Divided by 365 Days in the Year x 1%, an approximate Interest Rate)