If you expect volatility to decline, how can you ride the trend to profits? Butterflies offer intermediate to advanced options traders the potential to capitalize on a decline in Implied Volatility (IV). This post walks you through a real-world butterfly trade to show these concepts in action.

Lately my posts have been geared to beginning options traders (check out the latest back-to-basics post here), but I think it’s fair to interrupt this series for an advanced post about butterflies based on a real trade a TradeKing client told me about. It’s a great example of how to apply butterflies to capitalize on sudden volatility declines, one that may come in handy as the VIX and vol levels rise again.

There are many types of butterfly, but this particular play is a Long Butterfly Spread with Calls. (You’ll find more info on this under Education > The Options Playbook > Play #19.) It consists of 4 legs:

•    Buy a call, Strike Price A
•    Sell two calls, Strike Price B
•    Buy a call, Strike Price C

Generally, the stock will be at Strike B. Its max otential profit is limited to Strike B minus Strike A minus the net debit paid. Max potential risk is substantial, but limited to the net debit paid.

Butterflies are multi-leg options strategies involving additional risks and multiple commissions and may result in complex tax treatments. Keep the risk of early assignment in mind when constructing your own trades. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.

The trade was based on HGSI, Human Genome Sciences, Inc. Phase 3 experimental trials of a new drug were announced Monday 11/2 in the morning. At that point, IV was 250% for at-the-money (ATM) November options. These IV levels are sky-high, even for a high-volatility stock like HGSI, and any trade on this high-flying stock becomes a defacto volatility trade.

Here the client’s forecast was a large drop in implied volatility after the news announcement. By Monday’s end, IV on these same options had, in fact, declined to 70%.

I’ve blogged many times about butterflies being a trade that benefits from a decline in IV. For more on this, check out my post on volatility and butterflies; there’s also a webinar archive on the same topic. I also did a whole butterfly blog series that will provide more background.

So now let’s compare two trades: a simple call purchase and a simple butterfly purchase.

FYI… here is a recap of the day’s events.  The news of the trials was positive, and the stock opened 32% higher at 24.84 and closed the day at 25.28. Again, the ATM Nov implied volatility was 250%, and by Monday’s open it had dropped to 70%. The November options have 22 days remaining until the Friday expiration.

Now that you know the situation, which play would you choose? Both proved to be profitable trades – but can you guess which one yielded more?

1)    Buy 1 HGSI Nov 20 Call for $4.10, total cost $410 + $5.60 commission = $415.60
2)    Buy 4 HGSI Butterfly Nov 12.5/20/27.5 Calls @.90, total cost $390 + $17.45 commission = $407.45

If last Friday you bought one HGSI Nov 20 Call, on that day’s close (Friday 10/30/09) the call was trading for $4.10 and stock for $18.69. On the close Monday 11/02/09, the option was trading for $5.60, the stock is 25.28. You would’ve been right about direction and made $1.50 less commissions on your one lot trade. Total cash profit if closed would be ($150 – $5.60 commission = $144.40).

HGSI Long Call:
Buy 1 Nov 20 call @ 4.10

Break-even point at expiration:
20 + 4.10 = 24.10

Max potential loss: 4.10 plus commission
Max potential gain:  Unlimited
Commission $5.60

The call closed at $5.69 on 11/02/09

Now let’s imagine on Friday you bought 4 HGSI Butterfly Nov 12.5/20/27.5 calls for a net debit of .90. On Monday’s close, the closing sale of the butterfly was trading for a net credit of $3.00. You would’ve made $3.00 - $.90 = $2.10 per butterfly, but you were able to afford 4 of them. So the dollar gains were $2.10 x 400 = $840 - $17.45 commission = $822.55.

HGSI Butterfly:
Buy 1 Nov 12.50 call
Sell 2 Nov 20 call
Buy 1 Nov 27.50 call

Net debit of .90

Break-even points at expiration:
12.50  +  .90 = 13.4
27.50  –  .90 = 26.6

Max potential loss: .90 plus commission
Max potential gain: 7.50  - .90 = 6.60
Commission $17.45

Closed at a net credit of 3.00 for the sale of the butterfly on 11/02/09

What’s the takeaway? The fact that a butterfly wanted the IV to drop helped this trade’s returns immensely. Given the extremely high IV at the trade’s initiation, coupled with the fact that the butterfly requires us to sell two ATM options, makes the butterfly cheap to enter. The net effect is that we can buy more butterflies than long calls with the same amount of money and widen the long legs of the butterfly. In this case we were able to buy the 12.50 and 27.50 strike and still only paid a net 90 cent debit.

Now let’s look at the trade-offs of the two trades. Both trades have approximately the same risk upfront - the total debit paid for the trade. After the news hits, the long call really needs the stock to increase in price and would prefer the IV to increase as well.

In contrast, the butterfly can still be profitable if the stock goes up, down or stays the same, just as long as IV decreases – which seems to be the more likely scenario in this example.

If the stock price had increased 100%, the call would be the big winner and the butterfly would be the loser, but the stock “ONLY” jumped 35% to close at $25.28 - a big move. Meanwhile, the IV crunch of 180% was what the butterfly was really looking for.

On the butterfly, pay attention to the days to expiration for the options. If you’re too close to expiration, say only a week remaining, time decay is going to play as big of a role as the potential IV crunch. If the stock ends up outside of the long strikes (below 12.50 or above 27.50) at expiration, the butterfly would expire worthless. So stay 20 to 40 days out when possible, if you are treating it as mainly a play on IV.

Lastly, get out if the volatility drops as you forecasted; don’t turn this into a directional trade after the fact. That was not why you put on the trade. The goal here was to try to take advantage of a potential large drop in volatility, not to hope the stock will finish at the middle strike at expiration.

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

[image: butterfly 9 by eye of einstein on Flickr]

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