The name of today’s butterfly is called the skip strike, also referred to as the broken wing butterfly (hence the picture). This butterfly is used more often when a trader has a directional basis. You can put this one on with either calls, if you’re slightly bullish, or puts if you’re slightly bearish. The best thing about this butterfly is that it is usually done for a net credit to the account instead of a net debit.
Be forewarned, though: this strategy requires three different legs, and has additional risk above and beyond a standard butterfly, so it’s not one for beginners to try. However, if you’re fairly certain of a directional bump within a defined timeframe, this one can pay off nicely. Let’s walk through the potential risks and rewards and explain how this play works.
The set up…
As mentioned above, a skip-strike involves three legs. I’ll use calls in this example for a slightly bullish play, but the situation can be easily reversed using puts. With the stock somewhere near or below 40 (the lowest call strike) we would buy one of the 40 calls, sell two of the 42.50 calls, skip the 45 (this 45 would be bought for a standard b-fly) and buy one 47.50 strike. This trade is entered from the TradeKing standard butterfly trading page and is entered as a three-legged trade done for a net credit to the account (at least, in this example it is a credit). This means the trade is presented to the trading crowd as one “package” and that all three legs have to execute at the same time or none at all. In this example the credit we are looking for is 15 cents. This means we would receive .15 x 100 or $15 for each and every 1x2x1 butterfly we executed.
Skip -strikes with calls = short call spread + long butterfly spread call
You can think of this play as embedding a short call spread inside a long butterfly spread with calls, discussed in last week’s post. Essentially, you're selling the short call spread to help pay for the butterfly. Because establishing each trade independently would entail both buying and selling a call with 45 strike in this example, they cancel each other out and 45 strike becomes a flat position. Obviously the buy and sell of the 45 strike just generates unnecessary commissions so that is why we just “skip” that strike.
The embedded short call spread makes it possible to establish this play for a net credit (as in this example) or a relatively small net debit. [Butterfly -.30, Short Spread +.45, net +.15] However, due to the addition of the short call spread, there is more risk than with a traditional butterfly. The short spread has a margin requirement equal to the difference between the embedded short spread strike prices, in this case 2.50 (47.50 – 45).
Normally a skip-strike butterfly with calls is established with the stock below the lowest strike (40 call in this example), making it more of a directional play than a standard butterfly. This is done mainly because of the risk the short spread creates. Ideally, you want the stock price to increase somewhat, but not beyond 42.50 strike. If all goes well, the underlying does finish just below 42.50, the calls with 42.50 and 47.50 will approach zero, but you'll retain the intrinsic value for the call with the 40 strike. When done for a net credit, though, it becomes interesting: if the stock goes the wrong direction (down) the trade can still be profitable. All the options would expire worthless, and you would make the net credit received. Please see the Profit and Loss graph at expiration below for a fuller explanation of how this works.
P&L graph
As the P&L graph below shows, your hope here is that the underlying will bump up from its current level to 42.50 strike at expiration, and then stay there until expiration. If that happens, you’ll collect any premiums for the calls you sold at 42.50, plus you’ll capture the intrinsic value on the ITM call at 40 call. That call at 47.50 strike is merely there for insurance: in case the market sky rockets beyond 47.50, it caps off the total risk of the trade.
Let’s talk about risk (and reward)
Where’s our break-even, max loss and max gain on this trade? Let’s review each in turn.
First, the break-even for this example is 45.15. If established for a net credit (as in this example) then the break-even point is the 45 Strike (the skipped strike) plus the net credit received (+0.15) when establishing the play.
If established for a net debit, then there are two break-even points:
* the lowest strike plus net debit paid.
* the skipped strike minus net debit paid.
Your max potential profit is limited to the 42.50 strike minus the 40 strike, plus the net credit received in this case (42.50 – 40 +0.15 = +2.65). If done for a net debit it would be the same calculation, minus the debit paid.
Your max risk is limited to the difference between the highest strike (47.50) minus the skipped strike (45) minus the net credit received (47.50 – 45 - 0.15 = 2.35), or plus the net debit paid.
Factoring in implied volatility
After you’ve established a skip-strike, increasing implied volatility is your enemy. Your main concern is the options you've sold with the middle strike, or 42.50. An increase in implied volatility will increase the price of these options, so if you choose to close your position prior to expiration, it will be more expensive to buy them back.
In addition, you want the stock price to remain stable, but an increase in implied volatility suggests an increased possibility of a price swing.
You may want to consider running this play using index options rather than options on individual stocks. That's because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index's component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.
On the positive note, time decay is helping you out here. You’ve sold two calls at 42.50, so to achieve the maximum profit you hope to buy each of those calls for little to nothing at expiration and capture as much intrinsic value as possible in that long 40 call.
For all you bears…
For brevity’s sake, I’m going to skip the puts example of skip-strikes for now. If you’re a TradeKing client, you can look this play up simply by logging into your TK account and heading over to Education > The Options Playbook. Then click the tab marked “The Plays” and choose Play 23, Skip-Strike Butterflies with Puts.
Join me again next week for the next speculative butterflies play, ratio spreads, also known rather colorfully as Christmas tree butterflies. Until then, happy trading!
Regards,
Brian (OG)
[image: "Dog Eat Dog" World, or Bird Eats Butterly, as you may by Weaselmcfee 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.
