Bullsh*t Free Guide
To Butterfly Spreads
Your ultimate guide to butterfly spreads plus 7 unusual variations
By Gavin McMaster
Copyright 2013 IQ Financial Services, LLC.
All Rights Reserved
No part of this publication shall be reproduced, transmitted, or sold in whole or
in part in any form, without the prior written consent of the author. All
trademarks and registered trademarks appearing in this guide are the property of
their respective owners.
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Table of Contents
About the Author
Preface
1. Trading As A Business
2. Setting Up A System For Success
3. Choosing An Options Broker
4. Creating A Trading Journal And Trading Log
5. The Basics - What Is A Butterfly
a. The Butterfly Payoff Diagram
b. Should You Use Calls or Puts?
c. Some Things To Keep In Mind When Trading Butterflies
6. Why Trade Butterflies?
7. Thing To Keep In Mind When Trading Butterflies
8. Entering Trades In Your Brokerage Account
a. Entering Butterflies As A Debit Spread And A Credit Spread
9. How to Set Profit Targets and Stop Losses
10. How to Choose Strike Widths
a. Case Study: AAPL - 10, 25 and 50 Point Wings
b. Using Standard Deviation To Select Wings
11. How to Successfully Leg Into a Butterfly
a. Legging In With A Long Call
b. Legging In With A Debit Spread
c. Legging In With A Debit Spread
12. Butterfly Trading Rules Including Entry and Exit Signals
a. Underlying Instruments
b. Time To Expiry
c. Volatility Levels
d. Rules For Legging In
e. Adjustment Rules
f. Exits
13. Adjusting Butterfly Trades
a. Adjusting Profitable Trades – The Reverse Harvey
14. Butterflies and the Greeks
a. Delta
b. Gamma
c. Vega
d. Theta
15. Using Directional Butterflies for Low Risk High Reward Trades
16. Adding An Extra Put Or Call To Protect Against Fast Moves
17. Why Broken Wing Butterflies are the "One-Size Fits All" Strategy
a. Variation – Unbalanced Broken Wing Butterflies
18. Using Bearish Butterflies for Any Market Environment
19. Using Butterflies as Part of a Combination Strategy
20. Using Butterflies as a Hedge
21. Trading Weekly Double Butterflies
22. Reverse Butterflies
Final Words From Gav
Review Request
More Kindle eBooks From Gav
Excerpt From Bullsh*t Free Guide to Iron Condors
Other Recommended Reading
The information provided in this book is for general informational and education
purposes only. None of the information provided in this webinar is to be
considered financial advice. Any stocks, options and trading strategies discussed
are for educational purposes only and do not constitute a recommendation to
buy, sell or hold. Options trading, and particularly options selling, involves a
high degree of risk. You should consult your financial advisor before making any
financial decisions.
The material in this guide may include information, products or services by third
parties. Third Party Materials comprise of the products and opinions expressed
by their owners. As such, I do not assume responsibility or liability for any Third
Party material or opinions.
This ebook is dedicated to my sister Jenny who is always there for me.
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About The Author
My name is Gavin McMaster and I’m originally from Melbourne, Australia.
Currently I live with my wife Alex and 2 children (Zoe and Jake) in Grand
Cayman, which is where we have lived for the past 10 years. I’ve worked in the
finance industry for over a decade and have been trading options successfully for
the last 9 years.
My interest in the stock market can be traced back to primary school, I can’t
remember the teacher or which grade, but she told a fictional story which has
always stuck with me. It was a typical stock market tale of fear and greed, the
two most powerful emotions in the financial markets. A stock trader who bought
a stock at $1, watched in climb all the way up past $1000, but got greedy
assuming he would make more money. Of course some bad news about the
company came out and next thing you know the stock was back to $1. This was
a fictional story, but from that point on I was hooked. I bought my first shares
when I was 13 and have been trading ever since, although more heavily in the
last 10 years.
I started taking an interest in options in 2003 and have bought just about every
book you can think of on options trading. I also went back to school and
completed my Masters in Applied Finance and Investment in August 2009. Still,
there is only so much you can learn from a book and I have learnt so much more
from actually trading options.
My first experience trading options was buying some put options on an
Australian retail stock. I had no idea what I was doing and lost 100% on that
trade. One of my next trades was even more disastrous. I owned a small portfolio
of Australian shares and decided to generate some income by selling index call
options. I had no idea at that stage about delta or how to calculate my overall
exposure in order to create an effective hedge. My portfolio was mostly low beta
stocks and I had sold WAY too many index calls for my exposure. The market
rallied and my broker rang me that night to tell me I had margin issues. Instead
of just selling the positions and admitting defeat, I held on for another day and
the market continued to rally. All of a sudden my account had a negative value
and I didn’t have enough money in my account to fund closing the positions. In
the end, I had to borrow money from my brother to cover the margin call. A very
embarrassing experience let me tell you.
I’ve come a long way since that time and when I look back on some of the things
I did when I was starting out, it makes me cringe. I’ve worked and studied
incredibly hard and had many more ups and downs. I’ve been mentored by some
of the biggest names in the business – Dan Sheridan, Tony Sizemore and John
Locke.
With this ebook, I hope to share my experiences and help you avoid some of
those mistakes I made when I started out.
Preface
Butterfly spreads are an excellent income strategy, but they are one of the most
frequently misunderstood and poorly traded strategies among retail traders.
I see a lot of traders using butterflies and looking at the upper most point on the
payoff graph. It looks fantastic when you can potentially get a 600% return, but
realistically the stock will never finish right at the short strike and there are a lot
more things to consider with butterflies than just the payoff diagram.
After doing some research I realized there isn't a great deal of information
around regarding butterflies. It’s not one of those really popular strategies like
iron condors or covered calls where there is almost an overabundance of
information. The information available is spotty and very disjointed. With this
ebook I want to create the ultimate, one-stop shop guide to the butterfly strategy.
So, are you ready to come along for the ride?
You’re here because you’re interested in trading and growing as an options
trader. Maybe you have already tried trading but can’t seem to make a success of
it. Or maybe you are trying to develop as a trader and learn new strategies and
techniques. Either way, I admire you for the learning you are undertaking.
Learning is a lifelong experience; we don’t stop when we finish high school or
university. In fact, that’s the time when REAL learning needs to start. I want to
keep learning something new every day until I die. Either way, I admire you for
taking control of your own financial destiny.
I'm very conservative in my trading; I don't try to hit the ball out of the park with
every trade. I hit a lot of singles, and occasionally the fielder fumbles and I get a
double or a triple. A lot of people are lured into options trading with the thoughts
of making quick riches, but that is the last thing you should be thinking about.
Your mantra should be, "Take care of the downside, and the upside will take care
of itself." In other words, risk management is the most important skill for you to
master in this business.
Butterflies are a rewarding strategy to trade in your portfolio, if done correctly. I
hope you enjoy my insights into the wonderful strategy that will help you take
your trading to the next level.
Here’s to your success.
Gavin McMaster
1. Trading as a Business
The most important thing you can do when starting your trading career is to treat
is as a business. And that’s exactly what it is – a business. We are here to make
money after all. Would you start a business without a business plan? Of course
not, so why should trading be any different?
• Have a plan – My mantra is "Have a plan, trade your plan and review your
plan". I’ll go over how to develop a trading plan shortly, but this really is the
starting point. However, a trading plan is a constantly evolving thing, as you
continue to learn and test new ideas. You should review your trading plan at
least quarterly, and look at what worked and what didn’t and then adjust it
accordingly. The markets are also constantly evolving, so what worked in the
past my not work in the future.
• Learn from your mistakes – Just like in business, you will make mistakes in
your trading. It’s inevitable. Make sure you learn from your mistakes and
avoid making the same one twice. If you suffer a big loss because you ignored
your trading rules, hey, it happens. Just don’t do it a second time!
• Have very good risk management - Risk management is probably the most
important thing to master when it comes to successful trading. As I always say,
"take care of the downside, and the upside will take care of itself." No one and
I mean no one, can predict the absolute top or bottom of a market every time.
There is no magical charting indicator that will tell you either, so don’t get
caught up on the latest greatest indicator. The most important question you can
ask yourself before you make any trade is this, "What COULD go wrong?
What is my total risk on this trade?" Always know your worst case scenario,
and don’t think that just because a stock has fallen 80% that it can’t fall
further.
• Don’t trade on hot tips – It might seem obvious, but so many people still fall
for this one and just remember that if your taxi driver is recommending a
particular stock, chances are it’s too late to get in to.
• Stay level-headed at all times – The stock market is an emotional roller coaster
and it’s important to stay level-headed. This is where a good trading plan
comes in, as it takes the emotion out of the decision making process. Make
good decisions and you are already ahead of the game.
• Above all, enjoy what you do! – You won’t survive long in this business if you
don’t enjoy it. Personally, I absolutely love it and even when I have losing
trades, I still enjoy what I do. I love the challenge of trying to outsmart other
market participants. The money is just a way to keep score.
Homework Assignment: Think about 3 things that you are doing that a
professional trader would never do. Write them down and try to avoid those
things over the next 3 months
2. Setting Up a System For Success
One thing I encourage all my students to do is set up good systems and develop
consistent actions. There is a lot of information to digest and keep on top of such
as GDP releases, jobs data and earnings reports. At times, this will feel
overwhelming which is why it’s important to have a good system in place for
reviewing all potentially market moving events.
So how can you apply this to your trading?
Start working on your trading journal. Set aside a specific time each week and
spend 30 minutes filling in all your trades from the previous week. Also write
down how the market behaved and how that affected your positions AND your
emotions.
For me, I do this on Sunday evenings. During my routine, I check the following
and note down all my thoughts:
• Charts of the major market indices, including performance over the past week;
also noting relevant support and resistance and moving average lines.
• Chart of the VIX – Very important!
• Charts of the major commodities – e.g. Gold, Silver and Oil.
• Charts of important companies who have the potential to lead the market – e.g.
AAPL, XOM, FCX, GS, BAC, CAT
• Charts of various ETF’s – e.g. XLF, XLK, SMH, EEM
• Charts of any other stocks that are on my watch list
• Economic calendar for the week ahead
Reasons for creating rituals:
• It gets you into the habit of knowing what’s going on in the market and
increases your analytical skills
• Creates a reference library for you to refer back to
• Allows you to formulate an opinion of where the market might go.
• Allows you to devise trading strategies based on your market opinion.
Keep in mind that consistency leads to habits. Habits form the actions we take
every day. Action leads to success.
Homework Assignment: What systems could you set up to make your
trading life easier?
3. Choosing an Options Broker
Whether you’re just starting out, or if you’ve been trading for years, it’s very
important that you have the right broker. The cheapest broker may not be the
best, so here are a few things to look for: COMMISSIONS – Butterflies are a
commission intensive strategy due to the high number of trades you will make.
When choosing an options broker, commissions are probably the number one
factor people look at, but that does not necessarily mean it is the most important.
There are a few different ways brokers charge fees, so you need to figure out
which method works best for you. Here are a few ways they might charge fees •
Per trade, regardless of how many (or how few) contracts.
• Per contract.
• Fixed amount for a set number of contracts, e.g. Optionshouse charges $5 for
up to five contracts and $1 for each additional contract Generally if you are
trading a small number of contracts, it’s better to be paying per contract,
whereas large contract size would be better with a per trade fee.
QUALITY OF SERVICE – Not all brokers are created equal and each has
varying levels of customer service. Check to see if your broker has a good online
chat help, and ask a few questions to gauge their competence and wait time. If
you are just starting out with your trading, you may have a lot of questions on
how to get your trades executed, margin requirements or any other aspect of
trading. Having good quality service can be very helpful if you need some handholding early on. Generally, the cheap brokers will have less reliable customer
service than the more expensive ones. You get what you pay for after all.
TRADING PLATFORM – There’s not much point having a great broker with
good commissions if you can’t work their trading platform. Being able to place
trades quickly and efficiently can make a big difference to your stress levels.
You have enough to worry about just trading, without having to try and figure
out how to use your broker’s platform.
CHARTING PACKAGE – A good charting package is very important in my
opinion. Brokers such as Think or Swim have really good interactive charts,
whereas some of the others aren’t as good. With a lot of brokers, such as
Interactive Brokers, you have the ability to place trades with one click directly
on the stock chart, which is fantastic.
TUTORIALS – Another thing to check would be whether your broker offers
video tutorials of how to use the various parts of the platform. Some brokers
have extensive video libraries which can be a real help when you’re starting out.
EXTRA FEES – Some brokers have hidden fees that are not associated with
trading. These could be things like account minimum, inactivity fees and data
access fees. These can add up, if you’re not careful.
MARGIN – While I never trade on margin and definitely don’t recommend
doing so for Butterflies, a lower margin rate could be an attractive proposition
for some traders.
4. Creating a Trading Journal and Trading Log
Having a trading plan would have to be the most underestimated aspect of
trading, but a close second would have to be having a trading journal and trading
log. If you're not recording, reviewing and analyzing your trades, how can you
expect to know what works and what doesn't? A trading journal and trading log
are vitally important if you want to grow as a trader.
TRADING JOURNAL
A trading journal is where you write down your thoughts on the market each
week. You should include things like what happened during the week, what were
the newsworthy items and how they affected the stocks in your watch list, how
your trades performed and any emotional responses you felt and also any
potential trades you are looking at.
By doing this you will build up a database of information that you can refer back
to at a later date. This will help you when you come across situations that you
have experienced in the past. For example, you may have a trade go against you.
Check back and see how you reacted in similar situations and whether your
decision making process was correct. This type of analysis leads to better, more
informed decisions in the future.
TRADING LOG
Since the goal is to treat trading as a business, it’s very important to keep good
records. You need to record everything you do and periodically review your
trades and your decision making. This is how you improve on things you are not
doing well, and focus on the things you are doing well. If you click on the link
below, you can access a sample trading log that you can then adjust to you own
needs.
Visit http://www.optionstradingiq.com/tools and download the above sample
trading log and journal Homework assignment: Set up a time each week to fill in
your trading journal and trading log
5. The Basics – What is a Butterfly?
A butterfly is a neutral (generally), income-oriented strategy. It is a limited risk
and limited profit trade, but on a typical butterfly trade, the profit potential is
higher than the potential loss. Butterfly spreads involve 3 different option strike
prices, all within the same expiration date, and can be created using either calls
or puts. A typical butterfly would be constructed as follows: Buy 1 in-the-money
call
Sell 2 at-the-money calls
Buy 1 out-of-the-money call
The in-the-money and out-of-the-money calls are placed at an equal distance
from the short strike. A butterfly trade is entered for a net debit which means
money will be deducted from your account once the trade is placed. This is the
maximum amount that you can lose from the trade. The maximum profit is
calculated as the difference between the short and long calls less the premium
that you paid for the spread. For example if you had the following butterfly
spread: Long 1 June $95 call @ $5.00
Short 2 June $100 calls @ $2.50
Long 1 June $105 call @ $1.00
The total net debit to enter this trade is $1, which means the maximum profit is
$4. This is calculated as the difference in the strike prices from the short to long
strikes ($5) less the premium paid ($1). The potential return on investment is
400% and this would occur if the stock closed exactly at $100 at expiration. You
should be aware the achieving the full 400% return is extremely unlikely, but
more on that later.
The breakeven points for a butterfly are calculated as follows:
Downside breakeven = lower call PLUS premium paid ($95 + $1) = $96
Upside breakeven = higher call LESS premium paid ($105 - $1) = $104
In this example, the maximum loss will be incurred if the stock closes at $96 or
below and at $104 or above. You can see this on the diagram below.
THE BUTTERFLY PAYOFF DIAGRAM
As you can see above the butterfly payoff diagram, or expiration graph, has a
tent-like shape with the potential for very large profits around the short strike.
It's important to keep in mind that it's unlikely you would ever achieve the
maximum profit. In fact, some traders say that you should basically ignore the
top one-third of the butterfly expiration graph, as it unlikely and unrealistic that
your trade will finish in that area. The other problem with the top third of the
butterfly graph is that profits will fluctuate wildly, even with only small
movements in the underlying due to the high level of short gamma. The closer
you get to expiry, the higher the gamma will become, and the more your profits
will fluctuate.
A good aim for a butterfly trade is to make a 15-20% return on capital at risk.
Should You Use Calls Or Puts?
Butterflies can be traded with either calls or puts, it doesn't really matter. You
can also trade an iron butterfly, which uses BOTH calls and puts. An iron
butterfly is basically a combination of a bear call spread and a bull puts spread.
Generally speaking, traders will use calls for neutral and bullish butterflies and
puts for bearish butterflies but there is no real hard and fast rule. Iron condor
traders may prefer to trade iron butterflies.
Advanced traders might look at the relative skews of calls to puts. If puts are
much more expensive due to significantly higher levels of implied volatility,
they may prefer to use puts, but generally speaking the payoff is going to be very
similar whether you use calls, puts or both.
6. Why Trade Butterflies?
Unlike other options strategies such as iron condors and credit spreads,
butterflies are very dynamic and can be traded for a variety of different reasons
with different goals in mind. Some reasons to trade butterflies include: * Income
- Butterflies are a great way to generate income from stocks you think are going
nowhere in the short term. This can contribute to overall portfolio returns in flat
markets.
* Non-Directional - In their simplest form, butterflies are delta neutral or nondirectional trades. Trying to pick the direction of stocks or the overall market
can be stressful and expensive. Delta neutral butterflies can be set up with
strict rules to take the guesswork out of trading.
* Hedging - Market makers and advanced traders often use directional butterflies
as a short term hedge on positions that are moving against them. Centering the
profit tent of a butterfly around a strike that is under pressure in another trade
(such as a credit spread) can be a great way to control risk and allow you to
keep the original position open for a few more days. Sometimes that is all you
need for a trade to move back in your favor. At that point you can then remove
the butterfly hedge and stick with your original trade. Long-term out-of-themoney put butterflies can also be a much cheaper method of portfolio
protection than pure long puts.
* Low Maintenance - Butterflies are sometimes called "vacation trades" due to
their low risk and need for only very infrequent monitoring. Butterfly trades
are generally very slow moving early on in the trade. They can get a little
exciting and volatile when you get closer to expiry and are within the profit
tent though.
7. Some Things To Keep In Mind When Trading
Butterflies
Butterflies are a commission intensive strategy as you are trading 4 contracts
each time you enter a trade, and 4 contracts when you exit a trade. As most
brokers charge transactions fees on a per contract basis, this can soon add up and
should be taken into account when evaluating whether butterfly spreads are right
for you.
The greeks will be discussed in detail shortly, but basically butterflies are short
volatility, short gamma and long theta. Gamma is a very important aspect to be
aware of when trading butterflies, particularly as you get closer to expiry.
When trading multi-legged options strategies as one order, the bid-ask spreads
can be significant and therefore make it difficult to initiate a trade for a decent
price. If you choose to enter the 3 legs individually, you run the risk of the
market moving against you before having the entire position opened.
You can move the center strike of a butterfly slightly in-the-money or out-of-themoney to reduce the cost, however this gives the trade a directional bias.
Sometimes this can be a good thing and we will discuss directional butterflies in
detail shortly.
8. Entering Trades In Your Brokerage Account
The easiest way for beginners to enter a butterfly is to create a single order in
your broker’s option trader module. However, butterflies can be tricky to get
filled on when entered as one order. In addition, the bid-ask spreads can be quite
wide depending on the underlying stock that you are trading. You can see below,
3 separate butterfly spreads. SPY being the most liquid of the 3, has the tightest
of the 3 spreads with only $0.08 between the bid and the ask. AAPL is has a
slightly higher spread on both a dollar and percentage basis with a spread of
$0.69. RUT is the least liquid of all with a massive difference between the bid
and ask prices, on both a percentage and dollar basis. The dollar spread of $1.70
is very high; you might be able to get filled close to the mid-point, but you run
the risk of some slippage here if you are looking to trade butterflies on RUT.
Definitely something to keep in mind.
Entering Butterflies as a Debit Spread and a Credit Spread
If you’re having trouble getting filled on your single butterfly order, or you don’t
like the look of those bid-ask spreads, another way to enter your butterfly is as a
debit spread and a credit spread. After all, that’s all a butterfly is – a combination
of a debit spread and credit spread.
Looking at our AAPL example, you would buy 1 AAPL June 21 $425 - $450
debit call spread and sell 1 AAPL June 21 $450 - $475 credit call spread. You’re
looking at a bid-ask spread of $0.40 on the debit spread and $0.16 on the credit
spread. The total spread is less than our butterfly trade ($0.56 v $0.69). You will
also find it easier to get filled on two vertical spreads rather than one butterfly
spread.
The SPY spreads are fairly similar which makes sense given the huge levels of
liquidity. Trading the two vertical spreads has a total bid-ask spread of $0.09
compared to the single butterfly order at $0.08.
The bid-ask spread on RUT is similar to AAPL in that it is slightly lower when
entering at two vertical spreads - $1.50 v $1.70. So for RUT you will find it
easier getting filled using the two vertical spread method.
When starting out with butterfly trades, it is prudent to start trading highly liquid
stocks and ETF’s. SPY is one of the most liquid instruments in the world, so this
would be a good place to start for your butterfly trades. Try entering your trades
via the two methods presented above and see which method is easier to get
filled. Once you become familiar and confident with entering the trades and
getting filled, you can then move on to trading other instruments and trading
different variations of the butterfly which we will discuss shortly.
9. How To Set Profit Targets and Stop Losses
When trading butterflies it is easy to get caught up in the hope (a very dangerous
word in the stock market) of achieving the full profit as shown in the payoff
diagram. As mentioned previously, it is extremely unlikely that you will achieve
the full profit potential on a butterfly trade. A good aim for a butterfly trade is a
15-20% return on capital at risk and the maximum acceptable loss should also be
around the 15-20% level. As with most income strategies, you need to make sure
when you have a losing trade, you are not losing much more than the typical
gain you are making from your winning trades. Typically you should set a hard
stop loss at 1.5 times the average gain. So if you are generally making 15% on
your butterflies, your maximum loss on any trade should be around 20-25%.
When taking profits, you can also set time-based rules for taking profits. For
example, if you have made 10% within 10 days of opening a 35 day trade, that
might be a really good place to take profits even though your initial target was
15%. Achieving a healthy 10% return that early in a trade is a great thing and
sometimes it’s best to just say "thank you very much" and wait for the next
opportunity.
10. How To Choose Strike Widths
Where you place your wings (which are the bought options in a butterfly spread)
is a matter of personal preference and will also depend on which instrument you
are trading. How far apart you place the wings will determine how "fat" or
"skinny" your butterfly payoff diagram looks. Spreading the strikes out a long
way can increase the profit potential and move the breakeven points in your
favor, but it comes with the cost of having to allocate more capital to the trade.
Let’s take AAPL for example. In the following three diagrams, you will see three
different butterfly trades for the same expiration date, all centered around the atthe-money strike of $450. First we’ll look at a trade with 10 point wide wings,
then 25 points and then 50 points.
AAPL 10 POINT WIDE BUTTERFLY
Date: June 4, 2013
Current Price: $446
Trade Set Up:
Buy 5 AAPL June 20th, 440 calls @ $16.00
Sell 10 AAPL June 20th, 450 calls @ $10.25
Buy 5 AAPL June 20th, 460 calls @ $6.05
Premium: $775 Net Debit.
AAPL 25 POINT WIDE BUTTERFLY
Date: June 4, 2013
Current Price: $446
Trade Set Up:
Buy 5 AAPL June 20th, 425 calls @ $27.50
Sell 10 AAPL June 20th, 450 calls @ $10.25
Buy 5 AAPL June 20th, 475 calls @ $2.44
Premium: $4,720 Net Debit.
AAPL 50 POINT WIDE BUTTERFLY
Date: June 4, 2013
Current Price: $446
Trade Set Up:
Buy 5 AAPL June 20th, 400 calls @ $50.90
Sell 10 AAPL June 20th, 450 calls @ $10.25
Buy 5 AAPL June 20th, 500 calls @ $0.49
Premium: $15,445 Net Debit.
Rather than discuss the three variations individually, I feel it’s best to present
some of the key information in table format so we can compare.
Looking at the above table, you can see that there are some obvious differences
between the three variations. All of them are more or less delta neutral, the 50
width butterfly has a slightly higher delta, but it’s still fairly neutral. The big
differences come in when you look at the capital at risk (max loss), the potential
return and the Theta-Vega exposure.
The narrower butterflies require much less capital and therefore have a lower
maximum loss. The potential maximum gain compared to the maximum loss is
much higher for the narrow butterflies. The trade-off with this is that the wider
butterflies have a much higher range and therefore likelihood of profit.
The Vega exposure is another key difference; you can see that the 50 width
butterfly has a Vega exposure that is 10 times higher than the 10 width butterfly.
If you have a strong view that implied volatility is going to fall, you are better
off trading the 50 width butterfly.
The Theta to Vega ratio for the 10 width butterfly is almost one-to-one whereas
the ratio for the 50 width butterfly is just over 50%. A higher Theta to Vega ratio
gives you more capacity to withstand rising volatility. An as example, if
volatility increases 1 percent on day one of the trade, the 10 width butterfly with
lose around $24, but will gain around $21 in Theta decay which basically offsets
the loss from increased volatility. The 50 width butterfly will lose $224 dollars
from Vega and only gain $130 from Theta decay.
Based on the all of the information presented above, I think the 25 width
butterfly presents the best scenario.
Using Standard Deviation To Select Wings
Another consideration on where to place the wings is to see what a one standard
deviation move in the underlying instrument would look like. To calculate one
standard deviation you take price x volatility x the square root of the days to
expiry / 365. If that formula seems complex, don’t worry, I’ve created a simple
to
use
spreadsheet
which
you
can
download
from
http://www.optionstradingiq.com/standard-deviation-calculator/.
While the stock market is filled with statistical anomalies, generally a stock will
stay with a range of plus or minus one standard deviation about 68% of the time.
So if you place your wings around one standard deviation away from the current
price, you will have a winning trade roughly 2 times out of every 3. Of course,
nothing is guaranteed in the stock market!
Using the AAPL example above and my standard deviation calculator, you can
see that a one standard deviation move over the course of this trade would put
AAPL at either $472 or $420, so our 25 point wide butterfly looks like a good
option, or we could even stretch that out to 30 points in order to get our strikes
around the one standard deviation mark.
11. How To Successfully Leg Into a Butterfly
Legging into a butterfly spread should only be attempted by advanced traders or
those with at least one years’ experience of trading butterflies. Legging into
trades involves more risk because you are basically taking a directional view
prior to implementing the full butterfly spread. If that directional view turns out
to be wrong, you are behind the 8-ball from the start, and it’s a struggle to work
your way back. That being said, if your directional opinion is correct, you can
end up with a substantial profit or even risk free trade that you can ride into
expiration. We’ll take a look at a couple of different ways to leg into a butterfly –
using a long call, using a debit spread and using a credit spread.
First, let’s look at a standard butterfly so we can compare:
Date: June 4th 2013,
Current Price: $265
Trade Details: AMZN Butterfly Spread
Buy 1 AMZN July 19th $265 call @ $10.00
Sell 2 AMZN July 19th $275 calls @ $5.75
Buy 1 AMZN July 19th $285 call @ $3.10
Premium: $160 Net debit
Legging In With A Long Call
Suppose you were bullish on AMZN and decided to leg in using a long call. On
June 4th, with AMZN trading around $265, you buy a July 20th $265 call option
for $10.00. Two days later, AMZN has rallied to $275. You then sell two July
$275 calls and buy one July $285 call. Here are the details of the trade: Date:
June 4th 2013,
Current Price: $265
Trade Details: Legging in to a butterfly with a long call
Buy 1 AMZN July 19th $265 call @ $10.00
Two days later, AMZN has risen to $275.
Date: June 6th 2013,
Current Price: $275
Trade Details: Completing the butterfly
Sell 2 AMZN July 19th $275 calls @ $11.10
Buy 1 AMZN July 19th $285 call @ $6.70
Premium: $550 Total Net Credit
You now have a riskless butterfly where you will make at least $550. Even
though you are selling more options than you are buying with the second trade,
your broker will realize you already have one long call, so this will not be
considered a naked trade. Here’s how the payoff diagram looks, you can see that
this trade will make at least $550 no matter where AMZN finished at expiry.
Of course, this is all very easy in hindsight and much harder to do in practice,
but you can see that legging in to butterflies can be very lucrative if you can get
your timing right. Imagine for example, that you were legging in to this trade,
but AMZN dropped $10 rather than rising $10. At that point you would either
have to close out your long call for a loss, or if you complete the butterfly, you
would have a position where the majority of the profit tent is below the profit
line.
Legging In With A Debit Spread
Legging in to a butterfly with a debit spread follows a similar logic to using a
long call, but the risk and delta exposure are much lower. Taking our previous
AMZN example, let’s take a look at how this might work.
Date: June 4th 2013,
Current Price: $265
Trade Details: Legging in to a butterfly with a bull call debit spread
Buy 1 AMZN July 19th $265 call @ $10.00
Sell 1 AMZN July 19th $275 call @ $5.75
Date: June 6th 2013,
Current Price: $275
Trade Details: Completing the butterfly with a bear call credit spread
Sell 1 AMZN July 19th $275 call @ $11.10
Buy 1 AMZN July 19th $285 call @ $6.70
Premium: $15 Net Credit
By legging in to the butterfly with a debit spread, we have still managed to
create a risk free trade, although our profit will be smaller than legging in with
just a long call. Keep in mind though that our risk on the second trade is lower.
We only had to use $425 to create the second position rather than $1,000.
Let’s also compare the greeks of the two methods. You can see that there is a
much larger exposure to both Delta and Vega when using the long call method. A
slightly less significant consideration is the faster Theta decay, but considering
you would only hold the long call for 1-2 days before completing the butterfly,
this should not be your primary concern. The long call method of legging in has
higher potential profits, but as you would expect, along with that come higher
risks.
Legging In With A Credit Spread
Another method for legging in to a butterfly would be to use a credit spread. As
the previous examples have been on a rising stock, let’s take a look at a falling
stock - GLD
Date: July 4th 2013,
Current Price: $135
Trade Details: Legging in with a bear call credit spread
Sell 1 GLD July 19th $134 call @ $4.25
Buy 1 GLD July 19th $137 call @ $2.81
Two days later, GLD has fallen to $134.
Date: July 6th 2013,
Current Price: $134
Trade Details: Completing the butterfly with bull call debit spread
Buy 1 GLD July 19th $131 call @ $5.15
Sell 1 GLD July 19th $134 call @ $3.35
Premium: $36 Net Debit
This trade example doesn’t quite give you a risk free trade, but $36 is still very
low and gives you a potential profit of $264.
Reasons with you might want to leg in with a credit spread rather than a debit
spread include:
- Decreasing Volatility – If you think volatility will decrease, initiating the trade
with a credit spread will give you a short Vega exposure - Time Decay – Even
if it is just 1-2 days, initiating with a credit spread means time decay is
working in your favor rather than against you as with a debit spread.
If you are bullish on a stock, you can also leg in using a bull put credit spread. I
won’t go through the details as I think you get the idea. Basically you enter a
bull put spread to start, then once the stock has risen, you buy a bear put spread.
12. Butterfly Trading Rules Including Entry and Exit
Signals
There are many variations when trading butterflies, but for now let’s look at a
standard delta neutral butterfly and come up with some trading rules.
Underlying Instruments
The underlying instrument on which to trade butterflies is a key consideration.
Highly liquid stocks and ETF’s will help reduce slippage due to narrower bidask spreads, so this should be the first place to look for trades. The other
advantage of ETF’s and Indexes are that you don’t have to worry about earnings
reports. If a stock is reporting earnings during the life of your butterfly trade, it is
likely to have a huge move, not something you want on a delta neutral trade.
Most indexes are European style so there is no risk of early assignment, which
can be a problem for butterfly traders. This allows you to hold butterflies on
indexes until closer to expiry and potentially achieve higher profits. Indexes such
as SPX, RUT and NDX are great targets for butterflies.
For individual stocks, you want to be looking for stocks that are trading for at
least $75 and preferably over $100. The distance between strike prices is more
favorable and you can trade fewer contracts which help keep trading costs down.
Time To Expiry
For butterflies you generally want to be looking at the monthly expiration cycle,
particularly for beginners. Weekly options can be very risky no matter which
trading strategy you are using. The sweet spot is anywhere from 30-45 days to
expiry but some traders may also go out as far as 60 days. The minimum time to
expiry should be no less than 30 days though.
Volatility Levels
We know that butterflies are short volatility trades and that a spike in implied
volatility will hurt us, so it makes sense to enter butterflies when volatility is
high. However, volatility can be a double-edged sword. Sometimes high
volatility breeds more volatility. Also if you enter a butterfly when volatility has
spiked, that generally means the market has sold off sharply. Reversals from
those selloffs can be equally as sharp, which could mean the price blows right
back through the upper strike of our butterfly. Ideally what we want is a period
of steady or slightly declining volatility over the course of the trade, particularly
during the first 10-15 days. It therefore makes sense to look for an ideal range of
volatility levels. You don’t want to trade butterflies when volatility is at extreme
lows or extreme highs.
One way to look at volatility is to look at the range over the past 6 months or one
1 year and then disregard the top and bottom quarter. Let’s say implied volatility
for the instrument you are looking at has had a range between 10 and 30 over the
past 6 months for a range of 20. The top quarter of that range is between 25 and
30 and the bottom third is between 10 and 15. Now you have an implied
volatility range of 15 to 25 with which to work. Entering trades when volatility
is within these levels should give you a better chance of achieving success.
Rules For Legging In
We have previously looked at different ways to leg in to butterfly trades and this
is something you can incorporate into your butterfly trading plan. There are
many different ways to leg in and many different rules you can apply. A lot of
this comes down to personal preference and risk tolerance. Some traders will not
want to leg in due to the directional risk, while others may be happy with that
exposure.
For traders who want to leg in, your trading plan should include guidelines on
when and how you will leg in. The how indicates the method of legging in. Will
you use long calls and puts, debit spreads or credit spreads? When you leg in to
butterfly trades could be based on certain technical indicators or chart patterns.
Some people prefer RSI, stochastics or MACD but any directional exposure you
take by legging in should be planned in advance and detailed in your trading
plan.
Adjustment Rules
We will cover adjustments in detail shortly, but as a general rule, you want to
adjust your butterflies before the stock reaches your breakeven point. Some
traders will adjust their butterflies once the breakeven point is breached. I say a
better method is to adjust before the stock gets to that point. When looking at a
butterfly payoff diagram, you can break the profit tent into thirds. If the stock is
in the middle third, you’re fine. Once it breaks into either of the outer thirds, you
should look to adjust. Looking at the diagram below, provided the stock stays
between roughly $272 and $278 there should be no need to adjust.
Looking at it another way, this is the same butterfly spread after 1 week. You can
see how the profit line is very flat between $272 and $277 but really starts
accelerate downwards once you get past those points. This is why adjusting
based on the middle third makes sense and will help protect you from large
losses.
Exits
Choosing (and sticking to) your exit points is where a lot of traders fall down.
Getting into a trade is the easy part, knowing when to get out is the hard part.
With that said, let’s talk about some rules for when to exit a butterfly trade. For
simplicity’s sake, we will look at a standard butterfly trade.
The easiest and most enjoyable exit is when your profit target is hit. For a
standard butterfly, if you’ve made somewhere in the range of 10-15% within
about 10-15 days, then that is a very good time to take profits. You can create a
hard profit target if you prefer, such as exiting when you are +15%. With options
trading there are so many variables, so sometimes it is better to be a little bit
flexible with your rules. For example, if I’ve made 10% on a butterfly within 1
week, I would be quite happy to exit at that point even if my aim was 15%.
Never look a gift horse in the mouth because they market can take profits away
from you very quickly.
The other less enjoyable way to exit a butterfly is via a stop loss. Typically, the
maximum loss that you want to accept on a butterfly is around 20%, but your
acceptable level may be slightly higher or lower depending on your risk
tolerance.
Another method for exiting a butterfly is slightly less common but still an
important one, and that is using a timed expiry. As a butterfly approaches expiry,
profits can fluctuate wildly if the stock is within the profit tent. The last week of
an option’s life is referred to as gamma week for this very reason. Small
movements in the underlying can have a big impact on your bottom line. You
generally do not want to take a butterfly into expiry week. Some traders will be
lured in by the hopes of a significant return, but if you are treating your trading
as a business, then you should not accept huge fluctuations in your account from
one week to the next. Slow and steady wins the race.
13. Adjusting Butterfly Trades
The ability to adjust trades is what sets great traders apart from average traders.
Some traders may prefer not to adjust and just stick to the standard profit target
and stop loss. Adjusting can allow you to turn a losing trade into a profitable
trade, but it does involve risk and can make your trade more complicated. More
traders blow up their accounts through bad adjustments than through bad trade
initiation, so keep that in mind.
When it comes to adjusting butterfly spreads, there are plenty of ways to go
about it and I will introduce some of the more common methods.
For a neutral butterfly, some traders like to adjust once the breakeven point on
the profit graph has been exceeded. As mentioned previously, if you want to be a
little more cautious, you can adjust when the price moves into the outer third of
the profit tent. The other method is to adjust the trade when losses hit 6-7%.
Either method is fine, but keep in mind that when you adjust from a losing
position, you will either decrease your profit potential or increase your risk.
For any trading strategy, it is a good idea to have at least 6 months of experience
in a variety of market environments before allocating a significant amount of
capital to the strategy.
One method of adjusting a butterfly is to add a second butterfly once the
breakeven point on the profit graph is reached. The advantage of this is that it
gives you a new profit zone near where the stock is currently trading and gives
you a nice wide profit zone for the stock to land in. The disadvantage is that you
are allocating more capital to the trade. Generally it is not a good idea to
continue throwing more capital at a losing trade.
Here’s how it works.
On August 12th, 2013 with RUT trading around 1050, you enter a September
1030-1050-1070 call butterfly spread. Four days later RUT is trading at 1030
and you need to adjust.
Date: August 12th 2013
Current Price: $1050
Trade Details: RUT Call Butterfly Spread
Buy 5 RUT Sept 19th $1030 call @ $36.40
Sell 10 RUT Sept 19th $1050 calls @ $23.35
Buy 5 RUT Sept 19th $1070 call @ $12.95
Premium: $1,325 Net Debit
On August 16th, with RUT trading at 1030, we add a second butterfly centered
at 1030
Date: August 16th 2013
Current Price: $1030
Trade Details: Second RUT Call Butterfly Spread
Buy 5 RUT Sept 19th $1010 call @ $31.95
Sell 10 RUT Sept 19th $1030 calls @ $19.40
Buy 5 RUT Sept 19th $1050 call @ $10.15
Premium: $1,650 Net Debit
By making the adjustment we have added another $1,650 in risk capital to the
trade, and in effect created a profit diagram that looks like a mini iron condor.
The new position looks like this: Long 5 RUT Sept 19th 1010 calls
Short 5 RUT Sept 19th 1030 calls
Short 5 RUT Sept 19th 1050 calls
Long 5 RUT Sept 19th 1070 calls
Total Capital at Risk: $2,975
Maximum Profit: $7,025
With RUT at 1030, you don’t have a lot of room to move on the downside with
the breakeven point being around 1015. Theoretically, if RUT continues down
you can add a third butterfly, but this is again going to increase capital at risk and
decrease potential profits.
Here are the Greeks before and after the adjustment:
Another adjustment you might choose to make is adding call credit spreads. You
can do this in a couple of ways. Using the example above, with RUT at 1030 we
could sell some additional 1050-1070 credit spreads to turn the trade into
something that looks like a Broken Wing Butterfly. You could call it that, or you
could call it a Credit Spread With Protection. Either way, this is how you do it.
Date: August 16th 2013
Current Price: $1030
Trade Details: Adding Call Credit Spreads
Sell 5 RUT Sept 19th $1050 calls @ $10.15
Buy 5 RUT Sept 19th $1070 call @ $4.60
Premium: $2,775 Net Credit
We are bringing a large credit in for this trade, meaning the total net credit
received is now $1,450. The disadvantage is that we have significantly increased
our capital at risk when compared with the previous adjustment of adding
another butterfly. We now have $8,400 at risk in the trade as opposed to $2,975
in the previous example.
The other potential pitfall with this adjustment strategy is that you now have a
significantly short delta. That may be ok if your market opinion has changed and
you think the market is entering a new downtrend. But you may not want to take
such a strong directional exposure. Here is how the greeks compare:
As you can see, you now have a very short Delta at -65. Delta is also higher than
Theta whereas before the adjustment it was one third of Theta. The iron condor
adjustment gave you a delta neutral position.
If you like the look of the Broken Wing Butterfly adjustment, but are concerned
about the delta exposure, there is a way to cut delta without adding any extra risk
capital to the trade. We do that by adding some put credit spreads. Here’s how:
Date: August 16th 2013
Current Price: $1030
Trade Details: Adding Put Credit Spreads to Reduce Delta
Sell 5 RUT Sept 19th $980 puts @ $7.70
Buy 5 RUT Sept 19th $960 puts @ $4.90
Premium: $1,400 Net Credit
Your profit diagram at expiry now looks like this:
This extra piece of the adjustment has the added benefit of bringing in more
income, while not tying up any extra margin or capital. We have now received a
total net credit of $2,850 and our delta has been cut to -30.
With this last adjustment you should keep in mind that you now have a pretty
complex position that is going to be difficult to adjust if the trade gets into
further trouble. You want to weigh whether it is worth making this adjustment,
or if it’s better to just take your losses and close the trade. The other
disadvantage of this adjustment is the number of trades you are making is
increasing, so you are incurring more commission costs and more slippage
through the bid/ask spreads.
Adjusting Profitable Trades – The Reverse Harvey
The Reverse Harvey is an adjustment strategy developed by Mark Sebastian and
Dan Harvey. The idea behind the adjustment is that you want to lock in profits
on a winning trade. With successful butterfly trades, once time passes, the
sensitivity to movements in price increases. In other words, the slope of the
current risk graph becomes more pronounced.
If the stock makes a large move, your profits can quickly disintegrate. Due to
higher levels of short gamma the closer you get to expiry, your P&L will
fluctuate more wildly.
You can see this in the 2 diagrams below. With the stock right at the short strike,
a move of 30 points would result in a decrease in profit of roughly $1,500 for a
trade with 40 days to expiry and $8,500 for a trade with 10 days to expiry, quite
a significant difference!
Profitable Butterfly With 40 Days To Expiry
Profitable Butterfly With 10 Days To Expiry
The increase slope is caused by increased gamma as you approach expiry and
the fact that the wings provide less protection. If the stock is right at the short
strikes and there is not much time to expiry, the time premium of the outer wings
will have almost evaporated and no longer provide much of a hedge. For this
reason it makes sense to "tighten the noose" in order to protect profits as time
passes. This is where the Reverse Harvey comes in.
The Reverse Harvey involves selling the outer wings and bringing them in closer
to the short strikes. This provides more of a hedge for the short at-the-money
options and reduces the overall short gamma of the trade. As a result the profit
graph becomes more smoothed out again.
To watch the video by Mark Sebastian on the Reverse Harvey, visit this link. The
example given in the video by Mark is this: Date: Jan 4th 2011,
Current Price: $1274
Trade Details: SPX Iron Butterfly
Buy 10 SPX Jan 21st $1235 puts
Sell 10 SPX Jan 21st $1270 puts
Sell 10 SPX Jan 21st $1270 calls
Buy 10 SPX Jan 21st $1305 calls
After 3 days the trade is showing a decent profit, so Mark brings the wings in 10
points.
Date: Jan 7th 2011,
Current Price: $1275
Trade Details: Reverse Harvey Adjustment
Sell to close 10 SPX Jan 21st $1235 puts
Buy to open 10 SPX Jan 21st $1245 puts
Sell to close 10 SPX Jan 21st $1305 calls
Buy to open 10 SPX Jan 21st $1295 calls
This is the adjusted risk graph. The pink line is the adjusted position and the red
line is the original position. You can see that the risk graph as of today (dotted
line) is much smoother after the adjustment and the other added benefit is the
capital at risk is greatly reduced. Mark suggests performing a Reverse Harvey
adjustment once you are up about 5% on an Index butterfly.
14. Butterflies And The Greeks
Understanding option greeks is vitally important with most option strategies and
that is definitely the case with butterflies. Greeks for a neutral long call butterfly,
long put butterfly and iron butterfly are all going to be very similar. I will discuss
the greeks for a traditional neutral long call butterfly spread and you will know
that the same can apply to the other varieties of neutral butterflies.
Delta
A typical butterfly spread is set up with the short strikes placed at-the-money. It
doesn’t take a genius to realize that the delta of a neutral butterfly will be zero
(or very close to), but what happens when the stock prices moves away from
your short strikes?
If the stock falls, your butterfly becomes positive delta. If you think about it, this
makes sense. When the stock falls, your point of maximum profit is above the
current stock price, therefore you want the stock to rise. Positive delta indicates
that you will make money as the stock rises.
The opposite can be said if the stock rises. Your point of maximum profit is now
below the current stock price, so you want the stock priced to fall. Therefore,
you have negative delta.
This is shown graphically in the image below. The dotted line represents a
shorter dated option and the solid line represents a longer dated option. You can
see that the effect is more pronounced in the shorter dated option. In other
words, the delta (directional) risk is greater in shorter term butterflies.
Gamma
Gamma is a hugely important greek to understand when trading butterflies, as I
have previously alluded to. Important and frequently overlooked. Gamma is the
reason why the delta of a butterfly changes from positive to negative. For those
that are unfamiliar with gamma, a quick discussion might be in order before we
look specifically at butterfly gamma.
Gamma represents the rate of change of an option’s delta. An option with a
gamma of +.05 will see its delta increase by +.05 for every 1 point move in the
underlying.
Delta neutral trades don’t stay neutral for long and the reason is gamma. To
understand how gamma works, let’s look at an example. Assume you buy a 30
day, 50 delta straddle and a 90 day, 50 delta straddle. Both positions have the
exact same delta, so how will they perform if the stock makes a big move? The
one with the highest gamma will do better, in this case the shorter dated trade.
Gamma is at its highest with at-the-money options. Looking at SPY call options
with 16 days to expiry, you can see the gamma is highest around $161 - $163.
From this you can deduce that at-the-money butterflies have a large (negative)
gamma risk.
Gamma will be higher for shorter dated options as you can see below. Gamma
for the July at-the-money calls is around 0.08, whereas the September at-themoney calls are 0.03. For this reason, the last week of an options life is referred
to as "gamma week". Most professional traders do not want to be short gamma
during the last week of an options life.
Net sellers of options will be short gamma and net buyers of options will be long
gamma. This makes sense because most sellers of options do not want the stock
to move far, while buyers of options benefit from large movements.
A larger gamma (positive or negative) leads to a larger change in delta when
your stock moves.
When trading butterflies, it definitely pays to keep an eye on gamma. When the
stock is outside the wings of a butterfly, the trade has positive gamma. This
indicates that the trade will gain delta as the price rises and lose delta as the price
falls.
When the stock is right at the middle strikes, you have a large negative gamma
exposure. A large negative gamma means you don’t want the stock to move far.
This makes sense for a butterfly when you are right at the middle strikes.
As the stock moves up from the short strikes, the butterfly will lose delta (and
probably go from neutral delta to short delta as we discussed above). As the
stock falls from the short strikes the butterfly will gain delta (going from neutral
to positive delta).
The negative gamma exposure on a butterfly trade is a lot more than on other
popular income trades like iron condors.
Vega
Neutral butterflies are short Vega. The Vega exposure is similar to the gamma in
that you have a large short Vega exposure at the short strikes and positive Vega
outside the wings. So Vega works against you around the short strikes, but when
the stock starts to move away, Vega actually begins to work in your favor.
In the first few days of a butterfly, volatility will have the biggest impact on
profits out of all the greeks. For example a RUT 45 day at-the-money butterfly
has a Delta of -2, a Gamma of 0, a Vega of -31 and Theta of 4. Vega is by far the
biggest exposure and will have the biggest impact.
Butterflies have a very similar payoff diagram to a calendar spread, the main
difference being that butterflies are negative Vega while calendars are positive
Vega.
Theta
Theta is the exact opposite of gamma. You have a large positive Theta (you
make money as time passes) when the stock is right at the short strikes and you
have negative Theta (losing money as time passes) when the stock is out beyond
the wings.
15. Using Directional Butterflies For Low Cost High
Reward Trades
Using butterflies to make cheap directional bets is one of my favorite strategies,
so I’m going to enjoy writing about this topic. So far we have only looked at the
"traditional" way to trade butterflies, which is as a neutral income trade. You can
use butterflies in many ways, so let’s delve in to how you can use them to make
low risk, high reward directional trades.
A traditional butterfly involves selling two at-the-money options. When using
butterflies as a directional trade, we place the sold options out-of-the-money. A
trader with a bullish bias would sell 2 out-of-the-money calls and a trader with a
bearish bias would use out-of-the-money puts.
Before we go further into specifics, let’s first consider the reasons why you
might trade an out-of-the-money butterfly. The first reason is that it is a very
cheap way to gain directional exposure, or hedge an existing portfolio or
position. Let’s say you are bearish on SPY over the next few weeks and want to
take a directional exposure. The most obvious way to do this would be to simply
buy put options. The main problem with being long puts is that you suffer from
large amounts of time decay. The stock needs to start moving down soon after
you enter your trade, otherwise the position starts to decay.
SPY is trading at $161.20 on July 1st, 2013 and you think it might decline to
$155 over the next two weeks. You buy a July 19th $157 put for $0.89. Your risk
is $89, your profit potential is unlimited and your breakeven price is $156.11.
Date: July 1st 2013,
Current Price: $161.20
Trade Details: SPY Long OTM Put
Buy 1 SPY July 19th $157 put @ $0.89
Premium: $89 Net Debit
As you can see, this position starts to make profits below $156.11, but you were
only anticipating a fall to $157. Assuming your directional view is correct and
SPY drops to around $157 over the two-week period, a directional butterfly
would be a much better choice both from a risk and reward perspective. Let’s
analyze the trade: Date: July 1st 2013,
Current Price: $161.20
Trade Details: SPY Bearish Butterfly
Buy 1 SPY July 19th $153 put @ $0.39
Sell 2 SPY July 19th $157 put @ $0.89
Buy 1 SPY July 19th $161 put @ $2.06
Premium: $67 Net Debit
As you can see above, you are risking less capital, only $67 in this case, and
looking at a nice return if SPY ends around $157. We know achieving the
maximum return on a butterfly is unlikely, but it’s possible to make around a
$200 gain if SPY close between $156 and $158.50. To make the same $200 gain,
the long put would have to decline to around $154.
Risking $67 as opposed to $89 may not seem like a big difference, but for
someone trading 10 contracts, the difference would be $2,200 less capital at risk.
That's pretty significant, if you ask me.
Let’s look at some further examples of directional butterflies, this time using
RUT. First, let’s analyze a traditional neutral butterfly.
Date: July 1st 2013,
Current Price: $989
Trade Details: RUT Neutral Butterfly
Buy 5 RUT Aug 15th $970 call @ $36.45
Sell 10 RUT Aug 15th $990 call @ $23.90
Buy 5 RUT Aug 15th $1010 call @ $14.10
Premium: $1,375 Net Debit
Now let’s look at a RUT Bearish Butterfly:
Date: July 1st 2013,
Current Price: $989
Trade Details: RUT Bearish Butterfly
Buy 5 RUT Aug 15th $880 put @ $3.90
Sell 10 RUT Aug 15th $900 put @ $5.65
Buy 5 RUT Aug 15th $920 put @ $8.15
Premium: $375 Net Debit
Looking at the payoff graph above, you can see that this is a very attractive trade
from a risk reward standpoint. Risking $375 to (theoretically) make nearly
$10,000 is a good deal to me. Of course, RUT would have to drop around 10%
for that to happen, but you can’t argue with the risk reward ratio. This type of
trade is great to put on at the end of a long bull run when you think the market is
due for a correction, or you can use it as a very low cost way to insure a portfolio
of stocks.
There are a couple of other things to take note of here. The Vega on the bearish
butterfly is positive, whereas with a traditional butterfly it is negative. Also
Theta is negative, so time decay is working against you in this strategy.
Hopefully it’s obvious, but you are not using this as an income trade, which is
what butterflies are typically used for.
Lastly, let’s look at a directional butterfly using out-of-the-money calls for a
bullish trade:
Date: July 1st 2013,
Current Price: $989
Trade Details: RUT Bullish Butterfly
Buy 5 RUT Aug 15th $1030 call @ $7.20
Sell 10 RUT Aug 15th $1050 call @ $3.05
Buy 5 RUT Aug 15th $1070 call @ $1.20
Premium: $1,150 Net Debit
Here again, you can see a pretty favorable risk / reward ratio, but the trade is
much more expensive than the bearish butterfly, and in fact not that much
cheaper than the neutral butterfly. There are two reasons for this. First, put
options are skewed because markets tend to fall faster than they rise. As such,
out-of-the-money puts are more evenly priced compared to the calls.
Once you start to go deep out-of-the-money with the calls, those options have
very little value. You can see this in the option prices of the bullish and bearish
butterflies. The put strikes were traded at much more even prices - $8.15, $5.65
and $3.90. The calls were traded at a much greater variance - $7.20, $3.05 and
$1.20.
The second reason is that the bullish butterfly is not as far out-of-the-money as
the bearish butterfly. The sold puts are $90 below the price and the calls are only
$60 above. The reason for this is I wanted to have a similar delta (i.e. similar
probability) of the short strikes for both the puts and calls. The delta of the short
$900 puts was -0.12 and the short $1050 calls was 0.12.
At August 14th, a day and a half before expiry, RUT was trading at around 1050,
having rallied strongly through July and early August. The bullish butterfly
could have been closed on August 14th for $6,150, a profit of $5,000 on a
$1,150 investment.
A Few Things To Keep In Mind
Directional butterflies might be completely new to you, so let’s go over some
things to keep in mind before you dive in.
Butterflies are a net debit trade so we want to be paying as little as possible. You
have to weigh up the cost of the butterfly with how far you expect the stock to
move. The further out-of-the-money you go, the cheaper the trade will be, but
the less likely that the stock will end near your sold options. You can use delta as
a guide such as I did here, look at support and resistance levels, or use a standard
deviation measurement.
Short term trades are great with this strategy. I generally don’t advocate trading
weekly options, but in this case, directional butterflies using weekly options are
a great way to get leverage on your directional opinion. I find around 15 days is
a good sweet spot, but you can still go further out in time such as I did with RUT
above.
Set a price target for the stock and structure your butterfly with the short strikes
at that level. Try to think about where the market has the potential to go. Could it
move 5% in a week? 10% in a month?
You might find this strange to hear, but Theta and Vega are not overly important
in this trading strategy. The Neutral RUT butterfly has Vega of -73 and Theta of
44, but the directional trades were 18, -4 and 33, -11, so the exposure to these
greeks is much less of a factor with directional butterflies.
Given that you are risking such a small amount of capital, you can accept a
greater loss than you usually would for a traditional butterfly. For example with
the RUT Bearish Butterfly only requiring $375 of capital, I would be willing to
accept up to a 50% loss on the position.
It can make sense to hold these position until closer to expiry than you normally
would with a traditional butterfly. The leverage is what we’re after here, so it
makes sense to hold out for that big winner, given we only have a small amount
of capital at stake.
Unlike other directional trades, a large move in the opposite direction early in
this trade will not have dire consequences. Compare that with a long put or long
call, which can be decimated by an adverse directional move.
Using short-term directional butterflies can be a great way to hedge a credit
spread or iron condor that is under pressure, while allowing you to remain in the
trade.
Trading a butterfly in this manner is a directional trade, as you still need to stock
to move in the direction of your sold options in order to be profitable. The
benefit of this type of trade is that the cost of being wrong is minimal.
16. Adding An Extra Put Or Call To Protect Against
Fast Moves
Today we’re looking at how to protect your butterfly trades against fast moves in
the stock.
How often does it happen where you put on a trade and then within hours,
sometime even minutes, the stock goes on an absolute tear and leaves you sitting
on large losses? It happens all the time and it’s really annoying!
With butterflies, there is a way to give you a little bit of protection against this.
Let’s say you put on a neutral butterfly but are concerned that the market might
rocket higher. Adding an extra call can give you a great deal of protection
against this without adding much more risk on the downside.
Let’s look at an example:
Date: August 5th 2013,
Current Price: $170.70
Trade Details: SPY Neutral Butterfly
Buy 5 SPY Sept 20th $165 calls @ $6.80
Sell 10 SPY Sept 20th $170 calls @ $3.05
Buy 5 SPY Sept 20th $175 calls @ $0.80
Premium: $750 Net Debit
Now we’ll add the extra call.
Trade Details: Adding A Long Call To Protect The Upside
Buy 1 SPY Sept 20th $175 calls @ $0.80
Premium: $830 Total Net Debit
Looking at the payoff diagram at expiry, you might not immediately see the
benefit of this variation, as the stock would have to move a long way to the
upside in order to reach a profit. However, the main benefit comes if the stock
makes a fast move early on in the trade.
Let’s assume that SPY continues to rocket higher and climbs 5% in the next
three weeks to around $180. At this level, the standard butterfly would be
showing losses of $650, which is nearly a complete wipe out.
Image Credit: Optionshouse P&L Calculator
The extra call variation will be showing losses of around $220, which is
significantly lower than the standard butterfly, and all it cost you was an extra
$80.
Image Credit: Optionshouse P&L Calculator
17. Why Broken Wing Butterflies Are The "One-Size
Fits All" Strategy
In this chapter we’ll look at the "one-size fits all" strategy that is broken wing
butterflies.
Along with directional butterflies, broken wing butterflies are one of my favorite
strategies. How would you like a trade that provides income if a stock goes one
way, and capital gains if it goes the other way? That’s the potential you have
with broken wing butterflies.
A broken wing butterfly is sometimes referred to as a "skip-strike" butterfly and
you will understand why once you see the trade setup. A regular butterfly has the
bought options an equal distance from the sold options, whereas a broken wing
butterfly will skip a strike on one side of the trade. This reduces the cost and in
some cases will actually result in a net credit, meaning you can use it as an
income trade.
The other way to think about broken wing butterflies is that they are simply an
out-of-the-money credit spread, protected by a slightly narrower, closer to the
money debit spread. This is what the payoff diagram looks like:
Note that there is an (albeit small) income portion to this trade if SPX stays
below 1670 and a profit zone located between 1670 and 1690. The drawback
with this trade is the increased risk on the upside, but keep in mind the index has
to go through the profit zone before entering this danger area. Ideally you want
the index to slowly drift up into the profit zone and expire around 1680.
However, you also don’t mind if the index drops, in which case you would just
let the entire trade expire worthless and bank the income portion of the trade.
The above example is using SPX and assumes you are slightly bearish due to
some overhead resistance, but are concerned that momentum may carry the
index slightly higher. The income portion of the trade is $100 and the risk is
$900, which is an 11.11% return. Not bad considering you will make this return
if the stock: -Moves lower
-Stays flat
-Rises by less than 2.75%
Let’s not forget you also have the potential to make a large gain within the profit
zone. The upper breakeven point of the profit zone is around 4% higher than the
current index price so you have a reasonable margin for error. The best time to
make these types of trades is at the end of a long bull run, where the stock or
index is almost exhausted, but could potentially muster another 2-3% rally. If
that happens, you are in the profit zone, if the stock reverts to the mean, you
bank the income portion.
Keep in mind you can also do the same thing using puts, where you have the
income portion above the current stock price.
Hopefully you can now see why I love this trade. Here is how the above SPX
trade was set up:
Date: July 5th 2013,
Current Price: $1624
Trade Details:
Buy 1 SPX Aug 15th $1670 call @ $9.85
Sell 2 SPX Aug 15th $1680 calls @ $7.25
Buy 1 SPX Aug 15th $1700 call @ $3.65
Premium: $100 Net Credit
Let’s take a look at the same idea but using a standard butterfly. Instead of
buying the 1700 call for $3.65, this time we are buying the 1690 call for $5.30.
The increased cost of the 1690 call results in a net debit for the trade, albeit only
a small one.
Date: July 5th 2013,
Current Price: $1624
Trade Details:
Buy 1 SPX Aug 15th $1670 call @ $9.85
Sell 2 SPX Aug 15th $1680 calls @ $7.25
Buy 1 SPX Aug 15th $1690 call @ $5.30
Premium: $65 Net Debit
You might be able to better visualize the different trade setups using this table
below:
With the directional butterfly, you risk the prospect of full capital loss anywhere
below 1670 or above 1690. With the broken wing butterfly, you profit anywhere
below 1690, so the probability of success is significantly higher.
The broken wing butterfly also turns the trade into more of a bearish trade as you
will see from the option greeks.
On August 14th, SPX was trading around 1690, just inside the profit tent. The
1670 calls were trading at $15.30, the 1680’s were at $7.35 and the 1700’s were
at $0.55 meaning the entire spread could be closed for a credit $115. Adding that
to the $100 received at trade initiation brings the profit on the trade to $215, for
a 23.89% return on the $900 capital at risk.
Variation – Unbalanced Broken Wing Butterflies
Aggressive traders can take the features of a broken wing butterfly and take
things to the next level by trading an unbalanced broken wing butterfly. The idea
is that you have your regular broken wing butterfly and then add extra short
vertical spreads. You could also call this a ratio spread with out-of-the-money
protection.
This type of trade increases the income potential, but also increases the risk,
which is why I mentioned that it is more suitable for aggressive traders.
Using our SPX example, we can increase the income potential to $460, the
trade-off being an increase in capital at risk to $2540. Still that is an increase in
the income portion of the trade from 11.11% to 18%. Here’s how you would set
up
the
trade:
Date: July 5th 2013,
Current Price: $1624
Trade Details:
Buy 1 SPX Aug 15th $1670 call @ $9.85
Sell 3 SPX Aug 15th $1680 calls @ $7.25
Buy 2 SPX Aug 15th $1700 call @ $3.65
Premium: $460 Net Credit
The unbalanced broken wing butterfly becomes more of a directional trade than
the other two as you can see from the greeks below. You still get the nice profit
zone on the upside if the stock continues to rise, but this trade is much more
bearish due to the negative delta.
With the unbalanced broken wing butterfly, all of the greeks are significantly
higher than the other two trades; it’s a great strategy but it might take some
getting used to. You can read more about this strategy online at the Futures
Magazine.
18. Using Bearish Butterflies For Any Market
Environment
The Bearish Butterfly is an advanced rules based strategy developed by a friend
of mine called John Locke (no, not the guy off Lost). I won’t go into too much
detail here, but the basic premise is that you enter a butterfly below the current
stock price and then use reference points to add to, or adjust the trade. You start
with one-third of your total position size and then add the rest if the market
rallies.
Keep in mind the bearish butterfly trade outlined here is a high risk, high reward
trade so it’s not for everyone.
The trade is always entered with 56 days until expiry. RUT is the favored
instrument and the initial butterfly is centered 20 points below the current RUT
price. Your reference point is the center of the butterfly and the adjustment
points are then calculated as follows: Reference point +40 – add second 1/3
Reference point +60 – add last 1/3
Reference point + 70 – roll lowest butterfly +60
Reference point + 80 – roll lowest butterfly +60
Reference point + 90 – roll lowest butterfly +60
So assuming at initiation of the trade RUT is at 1050, you enter a butterfly with
1/3 of your position size, centered at 1030. If RUT then rises to 1070 (i.e. 40
points above your butterfly center), you add the second butterfly centered at
1050. If RUT then breaks 1090, add the last butterfly at 1070.
If RUT continues to rally and breaks above 1100, close the 1030 butterfly and
move it to 1090.
In terms of risk management rules and profit target the guidelines are set out as
such:
Start with 20 contracts (10 butterflies) for the short strikes and scale to 60
contracts if fully scaled into. Of course you can reduce these numbers if you
have a smaller account size.
Wing Span – Anything from 20 to 50 is ok. The wider the spread, the more
expensive the trade, but the larger the profit zone
Planned Capital - $50,000
Minimum Capital Suggested in Account - $100,000
Profit Target - $15,000
Reduced Profit Target - $5,000… 21 DTE or closer
Max Loss - $15,000
Some people like the rules-based approach of the bearish butterfly, but it’s not
for everyone. The strategy relies on the fact that at some point the market will
provide a pullback into the developing profit zone that you are creating with the
bearish butterfly. Markets that grind higher without much of a pullback, such as
we have seen a few times in 2013, can be a disaster for this trade. When this
trade loses, it can lose big.
19. Using Butterflies As Part Of A Combination
Strategy
So far we have looked mostly at using butterflies as a stand-alone trade, as both
neutral and directional trades. Another skillful way to use butterflies is as part of
a combination strategy or as a hedge for other trades.
Iron Condors are a popular income trade and adding at-the-money butterflies can
increase your Theta decay, potentially allowing you to exit the trade earlier for
the same amount of profit. Let’s take a look at an example: Date: July 31st 2013,
Current Price: $1052
Trade Details: Iron Condor
Long 10 RUT Aug 15th $980 puts @ $1.45
Short 10 RUT Aug 15th $1000 puts @ $2.45
Short 10 RUT Aug 15th $1090 calls @ $1.25
Long 10 RUT Aug 15th $1110 calls @ $0.35
Premium: $1,900 Net Credit
The payoff diagram is shown below. You can see we are risking $18,100 for a
profit potential of $1,900 for a return of +10.50%
.
Now if we want to increase our Theta and Vega exposure we can add a couple of
at-the-money butterflies. A ratio of 2 butterflies for every 10 condor spreads is
reasonable, but you can increase or decrease this depending on your opinion on
volatility.
Trade Details: Adding 2 at-the-money butterflies
Buy 2 RUT Aug 15th $1030 calls @ $28.30
Sell 4 RUT Aug 15th $1050 calls @ $14.30
Buy 2 RUT Aug 15th $1070 calls @ $5.10
Premium: $960 Net Debit
This gives us a profit diagram that looks like this. Notice that the capital at risk
has increased by the cost of the butterfly and that we now have a large profit tent
in the middle of the graph. The profit potential outside of the butterfly wings has
dropped from $1,900 down to $940.
This type of trade would be perfect after a volatility spike where you are
expecting the stock to trade sideways for 1-2 weeks. Let’s compare the greeks of
the iron condor and the combination position. The key points here are that your
Vega and Theta have both increased.
20. Using Butterflies As A Hedge
My preferred method for using butterflies as a hedge is when another income
trade such as an iron condor is moving against me and threatening my short
strikes. If you have ever traded iron condors, you will know that a stock
aggressively moving towards your short strikes puts your position under
significant pressure. Sometimes you will be forced to take losses for fear that the
stock might continue trending, resulting in rapidly increasing losses.
When this occurs, some traders will take losses and close the trade and some will
adjust and wait for the market to move back the other way before expiry.
Butterflies are a great way to hedge under pressure iron condors as I will show
you.
While keeping in mind there is no perfect hedge, incorporating a butterfly as a
hedge for an under pressure iron condor can achieve the following things: Reduce your delta exposure allowing you to contain losses
- Allow you to stay in the trade longer and delay taking losses
- Potentially achieve larger gains
- Ride the trend rather than fight it
Let’s look at an example of how this might play out. The following is a RUT
iron condor on July 8th where the short calls were under pressure. RUT had risen
from a low of $942 on June 24th to $1009 on July 8th.
Date: July 8th 2013,
Current Price: $1008.93
Trade Details: RUT Iron Condor – Calls Under Pressure
Long 5 RUT July 18th $940 puts
Short 5 RUT July 18th $960 puts
Short 5 RUT July 18th $1030 calls
Long 5 RUT July 18th $1050 calls
At this point, the short calls were getting a little too close for comfort and the
delta was getting to a point where it needed to be adjusted. Rather than the
traditional methods of rolling iron condors which increase capital at risk, I could
use a butterfly. Here’s how it could be done by adding the following trade:
Trade Details: Butterfly Hedge For In Trouble Iron Condor
Buy 2 RUT July 18th $1010 calls @ $10.30
Sell 4 RUT July 18th $1030 calls @ $2.65
Buy 2 RUT July 18th $1050 calls @ $0.45
Premium: $1,090
Doing this changes the profit graph to look like the following. Notice that there
is now a significant profit zone centered around the short call strike of $1030.
Making this adjustment has increased capital at risk by $1090, but that isn’t too
bad considering the alternatives. Keep in mind that potential profits on the
upside have also increased. The income portion of the trade has dropped from
$1500 to $410 but that’s ok as this hedge is more concerned with defending the
short strike of 1030. The delta exposure has been cut in half, so losses from any
further upside in RUT will be lower than if the condor was left as it was.
If in a couple of days, RUT declines, you can then remove the butterfly at a
small loss and then you have your existing condor back.
You can do the same move in the puts if the market is attacking your short puts.
Unfortunately in this case, RUT continued to move higher and the position had
to be closed for a loss. However, the butterfly hedge helped to keep losses lower
than they would have been from just holding the condor.
21. Trading Weekly Double Butterflies
Weekly options have become increasingly popular in recent years. In this
chapter, we’ll be looking at how to trade double butterflies using weekly options.
Using double butterflies to trade weekly options can work really well if you like
the idea of a "set and forget" strategy. With short-term butterflies you can enter
trades relatively cheaply, particularly if you move further out-of-the-money. By
using a double butterfly, you don’t care which way the underlying moves, as you
are creating profit zones to the upside and downside.
To set up the trade, you place a call butterfly spread above the current market
price and a put butterfly spread below the current market price. A good guide is
to have your short strikes centered just outside a 1 standard deviation move in
the underlying instrument. I like to initiate the trade anywhere between 7 and 10
days to expiry.
Generally this will be fairly cheap to set up. The reason I called this a "set and
forget" strategy, is that once you put on the trade, you leave it until expiry (note
you should only do this with European style Index options). This helps reduce
commission costs and slippage as there is no exit for the trade. As the trade is
cheap to set up, you are willing to accept a 100% loss on the trade.
Here’s an example of how you set up this trade:
Date: August 6th 2013,
Current Price: $1698
Trade Details: SPX Weekly Double Butterfly
Buy 1 SPX Aug 15th $1625 put @ $0.80
Sell 2 SPX Aug 15th $1650 puts @ $1.80
Buy 1 SPX Aug 15th $1675 put @ $4.80
Premium: $200 Net Debit
Buy 1 SPX Aug 15th $1725 call @ $1.60
Sell 2 SPX Aug 15th $1750 calls @ $0.35
Buy 1 SPX Aug 15th $1775 call @ $0.10
Premium: $100 Net Debit
Total Premium: $300 Net Debit
At the time of trade entry, a 1 standard deviation move would have put SPX at
1665 or 1731 at expiry.
Here’s how the profit diagram looks. Note that the trade is risking very little
capital and there are two very nice profit zones to the upside and downside. You
will profit anywhere between -4.10% to -1.50% and +1.80% to +4.30%. If you
got lucky and SPX settled at 1650 or 1750, you would collect a nice profit of
$2,200.
SPX ended up settling at 1657 for the August 15th expiry. The call butterfly
expired worthless resulting in a loss of $100 while the put butterfly made a profit
of $1600 thanks to the long 1675 put and short 1650 puts. Overall the trade made
$1500 in profit for a return of 500%.
This won’t happen every week of course, but this is a nice profit for a low stress,
inexpensive trade. You only need to a have a winning trade every few weeks to
make it worthwhile.
You can also increase your chances of success by waiting for 1-2 quiet weeks of
less than 1% movement before initiating the trade. This gives you a greater
chance that the index will move the required 1 standard deviation.
22. Reverse Butterflies
Reverse Butterflies are not an overly common trading strategy but they can have
their place in certain environments. Where you would normally enter a regular
neutral butterfly if you were expecting little movement in the underlying stock, a
Reverse Butterfly trader is expecting a large movement in the stock.
The right time to enter a trade like this would be if a stock has been trading
sideways for several weeks and you are expecting a breakout but are unsure of
the direction.
A Reverse Butterfly is constructed in the opposite way to a regular butterfly.
Instead of selling two at-the-money calls and buying the wings, you are buying
the two at-the-money calls and selling the wings.
Sell 1 in-the-money call
Buy 2 at-the-money calls
Sell 1 out-of-the-money call
As with a regular butterfly, the wings are placed an equal distance from the
middle strike. Here is an example of how a trade might look: Date: July 31st
2013,
Current Price: $1691
Trade Details: SPX Reverse Butterfly
Sell 1 SPX Sept 19th $1660 call @ $51.80
Buy 2 SPX Sept 19th $1690 calls @ $31.80
Sell 1 SPX Sept 19th $1720 call @ $16.40
Premium: $460 Net Credit
Notice that this trade is entered for a net credit so we are receiving money when
we place the trade unlike a regular butterfly. This net credit is also our maximum
gain for the trade. Here is how the payoff diagram looks.
This diagram is the exact inverse of a regular butterfly. The profit potential on
the trade is $460 and the maximum loss is $2,540 for a potential return of
+18.11%. Notice that the breakeven points are at 1665 and 1715, so SPX only
needs to move -1.85% or +1.16% for this trade to be profitable. Over a 7 week
period, it is very likely that the stock will move further than that.
If the stock does not move as expected, you would want to exit this trade well
before expiry to avoid the maximum loss. On a 7 week trade such as this one, if
the stock has not moved past the breakeven points after 3 to 4 weeks you would
want to exit.
A good profit target on this trade would be 10% but if the stock moves quickly
outside the breakeven points, you could hold until expiry for a full profit. Setting
a stop loss of between 10-20% would also be advisable.
When this trade was entered, the VIX was at 13.45, which was on the low end of
the recent 6-month range. It’s best to enter this trade when volatility is low and
that is generally the case when the stock has been moving sideways with small
daily candles. When volatility is low, the bought options are cheaper which
allows you to achieve a better potential return on the trade.
Reverse Butterflies are long Vega, which is another reason why this trade should
be entered when volatility is low and a rise in volatility is expected. Let’s take a
look at the Greeks. You can see we are more or less delta neutral for now, but we
still want a big move in the stock. The trade is long Vega as well, so a rise in
volatility will be beneficial.
Final Words From Gav
Congratulations! If you’ve made it this far, you’re well on your way to becoming
a successful butterfly spread trader. I put a lot of work into the book, and I
REALLY hope it helps you in some way. Here are a few final thoughts to leave I
would like to share with you.
YOU CAN DO THIS
Trading iron condors is not rocket science. You don’t have to be some whiz at
math, or technical analysis. Just start out by sticking to the basics and taking
things slowly. Even the greatest traders had to start at the beginning.
EVERYONE MAKES MISTAKES
There’s an old proverb (I think it’s Japanese, but don’t quote me) that says, "fall
down seven times, stand up eight". You will make mistakes along the way, I
guarantee it. I’ve made plenty. I’ve been trading for over 10 years and recently I
entered a spread order as a Buy to Open rather than Sell to Open, before I
realized my mistake I was down $600, then had to pay commissions and
slippage just to get the positions back to what I wanted. All up it cost me nearly
$1,000. So if you make a mistake, don’t fret about it. Get back up, brush yourself
off, and don’t make the same mistake again.
KISS – KEEP IT SIMPLE STUPID
Honestly, don’t try to overcomplicate or overthink things. Just keep it simple;
sometimes the simplest things are the ones that work the best.
DON’T BE AFRAID TO ASK FOR HELP
It’s a fabulous time to be alive; never in the history of mankind has
communication been so instantaneous and information so easily accessible.
There are loads of traders out there who are willing to help you. I’m more than
happy to help, so if you have any questions, please don’t hesitate to drop me a
line.
Review Request
I hope after reading this book, you have a much greater knowledge of butterfly
spreads than you did when you started.
If you enjoyed this book or if you found it useful, I’d be very grateful if you
would post a positive review. Your support really does matter and it really does
make a difference. I love hearing from my readers, I read all the reviews so I can
get your feedback.
If you’d like to leave a review then all you need to do is go to the review section
on the book’s Amazon page http://amzn.to/1bpIcn9. You’ll see a big button that
says, "Write a customer review" – click that and you’re good to go!
THANK YOU SO MUCH!
Thanks again, and I wish you nothing less than success!
Gavin McMaster
Link to book’s Amazon page:
[INSERT LINK]
More Kindle eBooks From Gav
Bullsh*t Free Guide to Iron Condors - Helping you avoid costly mistakes with
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Except From Bullsh*t Free Guide to Iron Condors
How To Handle A Low Volatility Environment
Low volatility environments can be especially risky for iron condor traders. High
volatility always comes after a period of low volatility, it’s a fact of life, but it
can be brutal for iron condor traders. When implied volatility is low, you might
look at a standard iron condor set up and think "Wow, this short strike is only 5%
out of the money, which seems way to close for my liking". Or maybe you’re not
worried about that and enter the trade anyway. Shortly after, the stock drops 4%
and all of a sudden you have a very large loss and a position that will be very
difficult to adjust and finish with a profit.
Low volatility makes iron condor trades difficult to find and hazardous to trade.
The high amount of Vega risk inherent in iron condors means that you are
susceptible to sharp market moves, which is exacerbated in period of low
volatility due to having to place you short strikes much closer to the stock price.
How then should we handle a low volatility environment? Should we stop
trading completely and wait for volatility to shoot higher? Yes, that is one
option, but probably not a very attractive option for you. Traders don’t like
sitting on their hands doing nothing, and no trades means no income. Luckily
there is a way to continue to trade iron condors and decrease your Vega risk. The
solution is called a "mouse ear" iron condor.
Mouse ear iron condors are basically a lower risk, lower return version of an iron
condor. They may look complicated to set up, but they are actually fairly easy,
albeit a little commission intensive. Mouse ears reduce your Vega risk and also
give you the potential to land in the "profit zone" and achieve a much larger
return.
This is what a mouse ear iron condor looks like:
Here is how the trade is setup:
Date: February 6, 2013
Strategy: Mouse Ear Iron Condor – RUT
Current Price: $911
Trade Set Up:
Sell 10 RUT Mar 14th, 960 CALLS, Buy 10 RUT Mar 14th 980 CALLS for
$1.00 ($100)
Sell 10 RUT Mar 14th, 840 PUTS, Buy 10 RUT Mar 14th 820 PUTS for $1.15
($115)
Premium:
$2,150 (2.15 per spread) Net Credit for the iron condor.
Total Capital at Risk: $17,850
Now add the ears:
Buy 3 RUT Mar 14th, 950 CALLS, Sell 3 RUT Mar 14th 960 CALLS for $1.15
($115)
Buy 3 RUT Mar 14th, 850 PUTS, Sell 3 RUT Mar 14th 840 PUTS for $0.85
($85)
Premium:
-$600 (2.00 per spread) Net Debit for the ears.
$1,550 total premium received.
Total Capital at Risk: $15,450
You can see above that I am basically adding a debit spread just in front of the
iron condor strikes which gives the payoff graph the appearance of having "ears"
at the short strikes. I’ve used a ratio of 3 debit spreads for every 10 iron condors,
but you can play around with the numbers and see what works for you. I’m only
using 10 point spreads for the debit spreads as opposed to 20 point spreads for
the condor which helps keep the costs down but also results in a narrower ear or
profit zone. Again, this is something that you can play around with to see what
works.
Even though this strategy has a potential for a higher return if the underlying
expires in the profit zone, you should be aware that it will be fairly unlikely as
the profit zone is quite small. The main benefit of this variation is that you will
fare better in the event of a sharp market move during the course of your trade.
You can see this via the different greeks.
Standard Iron Condor
Below you see the setup for our iron condor. The delta is skewed a little to the
downside as I was slightly bearish at the time. Notice that the Vega is -407.
Mouse Ear Iron Condor
Now, let’s take a look at our mouse ear iron condor. Delta is still negative
although slightly less so, but Vega is now -320 as opposed to -407. That’s a 21%
lower Vega exposure as opposed to the standard iron condor.
So you can see that a mouse ear iron condor has a lower exposure to Vega while
also providing an opportunity for extra profit if the stock closes within one of the
ears at expiration.
<< Get your copy of Bullsh*t Free Guide to Iron Condors >>
Other Recommended Reading
There are a couple of books that I recommend, but it depends on what stage of
you development you are at. For beginners, who still feel they need to learn
some of the basics of options trading, check out the following books: The Bible
of Options Strategies – Guy Cohen
Options Made Easy – Guy Cohen For those who have a good knowledge of
options, and want to take things to the next level, check out these books:
Options As A Strategic Investment – Lawrence McMillan
Option Volatility and Pricing – Sheldon Natenberg
Trade Your Way to Financial Freedom – Van Tharp Definitely check out some of
the above books - I guarantee you will not be disappointed.