Trade 12- Legging In

Butterfly morphing from long spread-a discretionary approach

Looking at a put butterfly for Jan 20th expiry, we have the following strikes and prices:
7050- 54,
7000- 41,
6950- 31.5.

Hopefully we all know that a butterfly comprises 1 long at higher value strike 2 shorts at middle strikes, another long at lower strike. In other words, sell the body, buy the wings. Here we can buy it for 54+31.5-(41×2)=3.5, with max reward at 50, if FTSE expired at 7000. How likely is that? Impossible to know, but it may be around 30% according to one source I use.

Another way of looking at a butterfly is as a combination of a long spread ( long 7050,short 7000) and a short spread (short 7000, long 6950). The outcome guarantees you cannot lose more than you paid, which is a comfort, but know this……..

Europe versus America

We trade European style-which means NO early exercise. There are American ETFs on indexes and the options are American style. It is possible for your shorts to get exercised/assigned anytime. Remember in this case you have SOLD the rights to those short options, so the market may just have a flash crash, and give you a loss. Using our pricing with American exercise, let’s say there’s a flash crash and your 7000 puts are suddenly worth 300 and these are exercised (you have to buy them back). You may not know about this until your smartphone says the bad news is that your shorts were exercised and you lost 300×2, or £6,000, but the good news is the market bounced back. Your longs are worth what you paid, 54 and 31.5= £855. This is why we trade FTSE European style index options exclusively. Equity options are American style.

About Morphing. Buy The long Spread for Openers?

How about buying the long spread,(7050,7000 for 54-41=13) and then waiting for a market drop to SELL the short spread?- currently 41-31.5=9.5.        A quick drop might see that short spread worth much more- say 15. We could then sell this and have a trade that has paid us to enter. It’s much more of a risk, and it’ll be fun to see how the approaches work out, in addition- we could also SELL the short spread on the basis the market might shoot on up. We might then buy the long spread for less money. Many traders like to ‘leg in’ and have their own preferred methods-we all have to find our own way.

 

 

Filed Under: InformativeStrategiesWeekly Trade Idea

About the Author: First found out about options in 1995.From the arcane magazine Exchange and Mart! First trade- a covered call on VOD in 1999. Made 10%,VOD almost doubled. That's when I realised I was not a good trader,and I was forgiven thanks to the amazing world of exchange traded options

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  1. Terrapin Trader says:

    Hope it’s clear that while you can enter a whole position, you can ‘leg in’ to any number of option strategies, in any order. No other trading vehicle gives you that flexibility,and almost limitless choices. You can vary the strikes, the expiry, the amounts and continually morph/adjust whenever you want.You can mix puts and calls in ‘iron’ strategies.You can trade volatility,time decay,direction. You can limit losses/gains,close out partially, it’s all about your own mindset.

    Everything else is frankly one-dimensional-you’re in the trade you win or lose.

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