By Charles Cottle

What’s the difference between a Butterfly, involving 3 equidistant strikes, and a BrokenWing Butterfly (aka BWB, Unbalanced Butterflies or ratioed verticals), also involving 3 equidistant strikes?

Answer: A certain amount of credit spread verticals that help to pay for the butterflies.

If you started with a 3 strike butterfly (like the 1by3by2 in Pink below), targeting a likely expiration range (you can use Diamonetrics™ for this) and you wished for a convenient way to pay for it, then you would sell additional credit spreads involving the existing short and long strikes of the selected butterfly.  To sell a greater amount of credit spreads is more aggressive, because it adds exposure to the potential liability in the event the market goes out of the range on the more heavily weighted side.  The more heavily weighted side in the image below is to the upside.

 Image Courtesy of Chapter 6 of “Options Trading: The Hidden Reality”(Exhibit 6-31)

To be most effective, it helps to have an opinion of where the underlying price may go and not go.  The most vital consideration in selecting strikes for all options strategies is establishing action points.  Action points consist of:

1. A predetermined entry point based on one's opinion of suppor and resistance until expiration
2. Exit levels based on the underlying violating support and resistance.  This is where the trader says: "I'm Wrong", and either liquidates the trade or adjusts it to represent a brand new market opinion.
3. Level for taking profits, harvesting baby butterflies, or parlaying profits with other adjustments.

Both Butterflies and BrokenWing Butterflies, involving the same strikes, play for the exact same target, i.e. the middle short “body” strike.  The BWB is more aggressive and requires more attention but I am happy to report that many traders are becoming very good at managing, adjusting and rolling the risks involved.

 

 

 

 

 

 

 

 

 

 

 

 

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.

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