Options traders don’t always realize how much volatility changes can impact their positions – even more so than changes in the underlying stock’s price. This post completes a blog series on volatility in options trading, discussing volatility’s effect on butterflies.
Welcome to the last post in my volatility series, folks. Today we’ll be discussing volatility’s relationship to an advanced strategy, the butterfly. (To catch up on my other posts, skip to the section below entitled “Just tuning in? Previous volatility posts in this series”.)
When IV is extremely high and you think it’ll come down, the obvious move is to sell a straddle (sell call and sell put with same strike price). But this is a considerable gamble requiring real skill, not to mention a sizeable margin requirement to hold the position because the strategy has unlimited risk.
Is there a less risky alternative? You could always sell the straddle and then buy some protection above and below your strike, just in case. Doing this creates a butterfly – we’ve sold the middle strike and bought the wings.
Let’s dive right into this discussion with AIG, a classic roller-coaster stock with frequent volatility swings in the past year. With AIG trading at 46.22 on 9/29/09 and implied volatility (IV) for the at-the-money (ATM) November legs at a sky-level 118%, let’s establish the following imaginary butterfly:
B-fly volatility example: AIG - 52 days to expiration.
AIG at 46.22 on 9-29-09
Buy 1 Nov 25 Put
Sell 2 Nov 35 Put
Buy 1 Nov 45 Put
Net debit of 2.18
Max Loss 2.18 (equal to the net debit paid)
Max Profit 7.82 (Strike C, 45, minus Strike B, 35, minus the net debit paid, 2.18)
Two break-even points, 27.18 and 42.82 (45 strike minus net debit, and 25 strike plus net debit)
Commission to establish the play would be $17.45.
If you’re following along in the Options Playbook, you’ll find this market-neutral play under Education > The Options Playbook > Play #20 Long Butterfly Spread w/ Puts. You’re hoping AIG will land at the middle strike, 35, upon expiration.
Two points to keep in mind. First, butterflies are multiple leg option strategies that involve additional risks and multiple commissions, and may result in complex tax treatments. Be sure to consult with your tax advisor before engaging in these strategies. Second, 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.
Another point: we’re doing this butterfly with a directional spin. Specifically, if we’re bearish on the stock, we’d use puts. We hope the stock will decline to the middle strike (35) from its current level, 46.22. The fact that the IV is over 100% would probably keep the cost of the butterfly low – in this example, the net debit to establish the trade is 2.18.
Since you’re selling two options, ultimately you’re hoping time premium of the middle strike option evaporates. A drop in IV or simple time premium erosion will help with that. The two long options limit our risk and provide some protection just in case the big move happens.
It’s worth noting that the October b-fly with the same strikes is, as I write this, trading for a 2.45 net debit. That’s more than the November b-fly we established above, but the October version has only 17 days until expiration.
AIG at 46.22 on 9-29-09
Buy 1 Oct 25 Put
Sell 2 Oct 35 Put
Buy 1 Oct 45 Put
Net debit of 2.45
Max Loss 2.45 (equal to the net debit paid)
Max Profit 7.55 (Strike C, 45, minus Strike B,35, minus the net debit paid, 2.18)
Two break-even points, 22.55 and 42.55 (Strike A minus net debit, and Strike C minus net debit)
Commission to establish the play would be $17.45.
This demonstrates how much high implied volatility can affect the value of a butterfly. If as expiration approaches AIG stays above the 45 strike, the October butterfly’s value will decline rapidly, but it does show in a real-world way why you may want to consider butterflies when the stock has extremely high volatility.
If all the variables in the market (stock price, implied volatility, interest rates) remained the same – there’s slim chance of that happening, but if it did – with the November b-fly at 17 days to expiration, you may have a profitable butterfly without the stock crossing below the 45 put strike.
Just tuning in? Previous volatility posts in this series
My first post outlined 3 key volatility terms: implied versus historical volatility and vega, the Greek measuring volatility’s affect on an option’s price. Post 2, Volatility: When Vega Trumps Delta, explained how volatility crunch preys on long options. Post 3 dealt with volatility and long call spreads, and post 4 moved on to volatility and short call spreads.
I dealt with calendar spreads next in two posts. Post 5 explains how, despite many traders’ expectations, calendars don’t benefit from super-low volatility. Post 6 described a phenomenon known as volatility tilt that can affect calendars around earnings season.
Post 7 dealt with position vega, plus I offered a free Options Playbook to the first reader to ask the pop-quiz correctly. Post 8 announces the winner and why his answer was correct. Last but not least, post 9 reviewed volatility’s effect on bear put spreads.
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
[Image: Screaming Blue & Orange by Tanki on Flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.
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.
Supporting documentation for any claims made in this post will be supplied upon request. Send a private message to The Options Guy using the link below the profile image.
TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.
(c) TradeKing, Member FINRA, SIPC. http://www.tradeking.com
