The contingent advanced order entry is a powerful feature that can be used in many ways. One way I really like to use this feature to execute orders is when I am trading neutral trades. With many neutral-market trades you’d like the underlying to go exactly to one price and stop. The two strategies I would like to focus on are the butterfly and the long calendar. If you need to brush up on these positions, check out my recent blog series on butterflies, which starts here, or my webcast on calendars, available only to TradeKing clients upon login from the Learning Center, under Educational Webcasts.
One of my general rules on neutral trades goes like this: if the underlying price equals the preferred strike price in the last 10 days to expiration, I usually close or roll.
With both of these strategies the max profit potential is usually reached if the underlying goes to the short strike close to expiration. Because of this similarity to butterflies, sometimes the long calendar is referred to as the “poor man’s butterfly”. The nickname “poor man’s butterfly” fits for several reasons. First, this strategy uses two legs instead of three in the typical b-fly, therefore saving on transaction costs. Long one month calendar spreads usually have a lower net debit upon entry than classic b-flies (depending on the width of the butterfly spread, of course). Finally, the P&L graphs of the two strategies are similar – see below – but you’ll notice that the upside is usually less with the calendar than the butterfly. As I’ve said over and over in this blog, there are ALWAYS trade-offs in options trading, so it’s no surprise that a cheaper alternative to one strategy would also probably have a lowered profit potential.
Long Butterfly Profit and Loss Graph at expiration
Long One-month Calendar Profit and Loss Graph at the expiration of the front month option
Now this post isn’t intended as a comparison cage-match between butterflies and calendars; it’s more about managing them. I have stated many times that trying to eke out the last few cents of profit on a trade is usually not worth the risk. So how might we implement the rule-of-thumb I outlined above, about closing or rolling when my underlying hits the preferred strike within 10 days to expiration? The answer is the contingency order in TradeKing’s Advanced Orders menu. You can place contingent orders from both the calendar spread and the butterfly order entry screens. To start with we’ll concentrate on the butterfly spread contingent order entry.
For the butterfly, then, let’s enter an order to sell to close an MNX (Mini-NASDAQ 100 Index) butterfly when we have 10 days left in the expiration cycle. With 10 days to go, the order would be to close the following butterfly, contingent on the underlying index being greater than 190; it was at 185 when the order was first entered. Please click on the pictures to enlarge them.
STC MNX Aug08 $185 CALL MNX HQ
BTC MNX Aug08 $190 CALL MZX HR
STC MNX Aug08 $195 CALL MZX HS
The contingent criteria is then entered in a box that pops up directly below the action section. Make sure you check where the index is currently trading, so you know whether to select “more than” or “less than” in the trigger price dropdown. Here the index is below our trigger, so we select “more than” in the dropdown and enter 190 as our price. We should also make this a good until canceled (GTC) order, so make sure to select the GTC radio button, too.
Now for the limit credit. We’re selling the butterfly to close the position, so we should receive a credit for the trade. If it hits the short strike in this timeframe, I would hope we could get 80% of the max gain. So since the max is 5 (190 strike – 185 strike), let’s make the credit 5 x 80% or $4. I have mentioned many times how hard it can be to get the last 20% of value out of a trade – that’s why I’m aiming for 80% of the width of the spread in this case. So, with this caveat in mind, let’s enter the trade with a limit credit of $4.
Keep in mind $4 is once again a guess, so if you can please check the credit quotes after the trade is entered and make sure the limit credit is in the ball park and gives you a fighting chance at a fill. Also, with any 3-legged trade I try to avoid entering market orders, and obviously a butterfly has three legs in it.
With the long one-month calendar trade we would buy to close the front-month option and sell to close the back month option. We’d do this when the underlying was equal to the short strike price of the front month option, with 10 days remaining to expiration.
As I think of more uses for our new contingent order entry, I’ll be sure to fill you in future posts…
Regards,
Brian (OG)
[image: Ithomia, or visit of the naked butterfly by e3000 on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
