Trade of the Week 8- it’s time to get with a Strategy

trade8-butterfly

The above is a screenshot of 3 separate calculations from iVolatility.com and prices from the ICE.com.

What is a Butterfly? Wings and a Body Low Risk big Reward

This is a trade that may appeal to many-the above uses puts expiring on 16th December. Its maximum profit is at 6700,and cost: Buy 1 6800 put for 81, SELL 2 6700 puts 52×2=104, BUY 1 6600 put for 33. Thus you pay 81+33= 114 minus  104=10.     So a trade costing 10 could make 100. Maximum loss=10. We touched on the butterfly effect in the last trade-which was with calls and profited at  >7000. This trade profits from a drop to 6700. Which is right? We cannot know,but we have the 2 conflicts-the Santa rally and the dreary FTSE rally that’s ground to a halt.

Good Trade or Bad Trade?

It’s no bad thing to have limited risk and possible 900% profit( if that’s right).  So what’s the deal? In the above calculations we are about flat in terms of volatility we are gaining from theta(time decay)

The 2x6700s have theta of 2×2.3512=4.724,against the 6800 and 6600 that we own(2.457+2.0397=4.4967) Now this is not a lot in real terms but at least we are not burning cash. Remember these are static calculations and prices are dynamic. In fact in a butterfly most of the Greeks ‘nett off’ so it’s a neutral trade but in our case, directional. It will make ££££ if FTSE drops in the next 3 weeks. There may be a chance to cash out,before expiry, but at what price? What if it’s a loser?

Exit IS Everything

I’m a rubbish trader and can lay claim to a butterfly I paid 8 for and it traded at 40- I tried to close at 41,and guess what?       Next day it went to almost nothing, as the market smashed up. YOU must decide where AND HOW to close, and that is really the key.

The Cadillac Trade

Multi leg strategies such as butterflies have been known as Cadillac trades as the commissions are quite heavy and hence the broker will be buying the Cadillac! On InteractiveBroker.com I think comms are still about £1.80 a lot, so the above would cost 4x£1.80.

Filed Under: StrategiesWeekly 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:

    We will discuss exits( or closing trades) soon but getting heads around concepts is what we need to achieve firstly. It is hoped that our trades are being scrutinised and I make no apologies for being opportunist at closing out ‘paper trades’. It’s just not possible to tailor trades according to other people’s personalities. I’ve met all kinds of traders and I am certain everyone has a different risk profile-it would be fun to get you guys to post how you would have traded these. It is also not possible to show all the variants,though maybe we can do this at some point. I will laugh if trade 8 goes all the way, so please don’t think I’m in any way a guru. I’m just a passionate trader who sees opportunities in option prices.

  2. Chris says:

    Loving the content. So are butterfly mainly for when you’re not sure which direction a stock is going in, but you know a big move is about to be made?

    • Terrapin Trader says:

      a butterfly makes money when the highest price option is ‘in the money’ at expiry while the ‘body’- in our case the 6700 puts are just out of the money. It is zero risk from the amount you pay, as it is long(bought) spread 6800/6700 and a short (sold)spread 6700/6600 which cancel each other out, so you want the range of the underlying FTSE to hover around the 6700(the body) area.(You can target a ‘price range’ cheaply in other words). At expiry if FTSE=6700, the 6800 put that we own is worth 100, the 6700s are worth zero, and the 6600-which we only bought for insurance, is also worthless. So we just want the FTSE in the 6800-6700 zone. Does that make it clearer? You do not have to have much of a clue to make money in reality-unlike other trading. With options you can be wrong about direction but make money-so if FTSE is below 6800 at expiry we make money. Exit is the problem-to be discussed at a later stage. If you’d like a more personalised reply, let me know. This is about concepts-think of it in the same way as Sudoku.

    • Chris, it’s usually the opposite for a butterfly, the maximum payout is when the stock/underlying remains around the strike price of the two short legs. I tend to regard butterflies as covered short straddles (and vastly prefer them to that trade as a result)

      You can use them directionally (which I think is what David has done in this example) where the body (2 x short positions) is above or below the money, depending on whether you’re bullish or bearish. If I’ve read the numbers properly, David’s butterfly is currently bearish as the short strikes are at 6700 and the FTSE is around 6800.

      The main snag with this strategy from a directional perspective is that you’ve got to be fairly precise about the price destination on (or near) expiry, that’s what gives it the higher risk/reward. You can adjust by adding more spreads at different strikes, but they usually reduce the profit potential too. Adjusted butterflies tend to start looking like condors after a while.

      I’ve written an article about butterflies here which has a few links/videos etc also: http://options.marketglossary.com/butterfly-spread

      There is a basic butterfly template they’ve provided on options creator that you can play around with: http://optioncreator.com/long-butterfly

      The Charles Cottle book that David recommends is a good one, but it’s not exactly an easy text for beginners. The Gavin McMaster title is an easier intro to butterflies (and it’s about two quid on Amazon): https://www.amazon.co.uk/BULLSH-FREE-GUIDE-BUTTERFLY-SPREADS-ebook/dp/B00FGYTA42 The Dan Sheridan videos on YouTube about butterflies are worth watching too and cover a lot of these kinds of trades.

      • David Eppel says:

        good spot Ralph- I like the ‘targetted’ butterfly as a big win/low cost trade with zero risk of ruin. I have no more clue on the market than anyone else bu if there’s any weakness in the next 2 weeks we could see a good return. I’m hoping to ease people into the options mindset,and Cottle is a bit of a stretch even for us seasoned campaigners. I have been checking out some equity options but I just find them too awful as there are too many variables for my liking-keep a weather eye on here,though as I think it’s anarea of interets to those who own shares.

        • The targeted butterfly is not a bad idea. I like the risk/reward, it’s one of these strategies you could pay for with some spare change from a higher probability setup and not worry about it too much if it doesn’t work out.

          On the market conditions, everyone always seems to go on about the Santa rally at this time of year, but in 2014 & 2015, it was pretty late showing up. In early December you seem to get more like the ‘Christmas Party Hangover’ effect instead and the market drops off – sometimes quite a bit. So I reckon your trade idea might be worth a punt and it could work with more or less any major index underlying.

          There’s an interesting article about December performance for the FTSE here: http://stockmarketalmanac.co.uk/2016/12/the-stock-market-in-december-4/

  3. Terrapin Trader says:

    You may wish to look at the work of Charles Cottle-the butterfly guru and all round nice guy who gives away much of his excellent work.

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