Before I push forward with more butterflies, I wanted to highlight the butterfly chain on the TradeKing web site. It’s one of my favorite chains mainly because you can see, on one underlying, an entire chain of standard butterflies or of skip-strike butterflies on one page.

To get there log into your account and select Option Chains under the Quotes + Research tab. Our example today is the CBOE mini-NDX index (MNX). This is a decent index in that it has 2 ½ point strikes, so it will be easy to show a standard butterfly and a skip-strike.

In the column headings we type MNX and select Near-the-Money for the strike, Butterfly Call Spreads and June expiration.

The chain shows Option 1 (this is the lowest strike price), Option 2 (this is the middle strike) and Option 3 ( this is the highest strike). Under the butterfly it shows the bid mid and ask for the butterfly, assuming we did a 1x2x1 ratio. Another way to say that is that we bought one contract of option 1, sold two contracts of option 2, and bought one contract of option 3. Our Options Chain tool will default to the smallest interval possible, in this case strikes 2.5 points apart. If we want wider butterflies, all we have to do is click the drop down for the intervals and select wider strikes and hit go again.
 
When entering a long butterfly the price we should be focused on is the “mid” price quoted in the third column; we want to enter our limit price for the entire butterfly close to the mid price. If we can’t trade close (within a nickel of a dime) to the mid price then we need to find a better product to trade butterflies in.

So let's place a butterfly trade. Since we're using calls, that introduces a slightly bullish spin on the trade. With the MNX index at 199.06, we're buying 1 of the 200 strike, selling 2 of the 202.5 strike, and buying one of the 205 strike. This butterfly is highlighted in the first screenshot. I will click the mid point (0.20) and adjust the limit to a net debit of .25, then click the Preview Order button in the middle of the screen - voila! I've entered my butterfly.

If we want to enter a skip-strike butterfly, let’s adjust the second interval box to an interval of 5 and keep the first box to an interval of 2.5 and then click go… See  the screenshot below. Since this is a skip, we’re going a little further out-of-the-money and buying one of the 205 strike, selling 2 of the 207.5 strike, skipping the 210 strike and  then buying one of the 212.5 strike. Don’t forget: as discussed in my blog post on skip-strikes,  there’s additional risk if the market goes up on a skip strike butterfly with calls.

In the next screen shot, you’ll notice the quotes are negative, Bid (-0.55),  Mid (-0.39) Ask (-0.22). This is because we are actually buying a butterfly for a net credit. We can only do this because we embedded the short spread inside the butterfly – again, please refer to my blog post on skip-strikes for more info.  

Once again we click on the mid price in the final column. You will notice in the butterfly order entry screenshot (below) that the credit box is highlighted, I would enter the number of contracts and adjust the credit to about .35 from .39 and then click the preview order button.

TradeKing’s Options Chains are full of great features, but I think it handles butterfly trades especially well. Join me next week for a new butterfly strategy!

Regards,
Brian (Og)

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. 

 

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Very nice Brian. Very informative series.

Question, in the previous skip-strike butterfly blog, you mentioned that the third leg (buying the upper call at 47.5 in that case is merely there to cap the downside risk). But, since you say these are best done for index options so that there is lower volatility, it would seem that it would be maybe not so bad to just skip out on buying that upper leg (3) call. I definitely realize that this would no longer limit your loss, but perhaps the gain/risk ratio is improved in this situation, especially with a non volatile stock, or index?

By the way, the images are still a little hard to see...

Hello Locogmac,

Thanks for the kudos. Yes, trying to use a less volatile underlying will reduce some of the risk, but in this case not buying the 47.50 strike means one of the sold calls at the 42.50 strike would be a naked call. First of all this means you have to be approved to do naked call writing and next there would be a large margin requirement that comes along with that naked position. So the extra capital you would have to put up to be naked would diminish greatly the return on investment, so not quite as big of a gain/risk ratio reward as you might think. Not to mention that I would never tell anyone to ever be naked an option. I don't go naked, so I would never recommend anyone else to. If you traded options for as long as I have you will find that the unexpected happens much more often then you think. It might not happen this year, but I guarantee over the next 5 years it will happen a couple of times and it only takes once.

As to your second comment "By the way, the images are still a little hard to see". To that I say "Major understatement - they suck!" I will try to fix them soon :-).

Regards,
Brian (Og)

Hello All,

I did a work around on the pictures today. You have to link to a different window, but at least you can see an entire view of the screen shot by just clicking on the pictures in the post.

Let me know if it works and if it is an okay solution.

Regards,
Brian (Og)

Thanks Brian, I forgot about the margin requirement part. I guess since I've never been able to do naked options yet, I really couldn't understand that amount of risk that would entail. I guess it's like the unlimited risk of shorting a stock, but 100x leveraged. So, I see how that can be real dangerous and why you would never be naked an option.

And, the pictures are a lot better. Except, you only need to single click, not double click. :) 

Thank you guys both for that dialogue.  That answered my question about the butterfly strategy, but I feel that topic largely goes uncovered in "The Options Playbook."  Even after reading it a million times I'm still nervous about placing a spread.

 On basic spreads, is the naked factor covered by the presence of the purchased call?  Sorry, I know this is off topic.

Hello NeoBull

If you were to do a bull call spread or also called a long spread with calls. The lower strike is usually bought and the higher strike is sold. Example would be to buy the 50 calls and sell the 55 calls. This would mean you have the right to buy stock at 50 and the obligation to sell stock at 55. Since the right to buy is at a lower price then the obligation to sell, this means the sell of the 55 call is covered and there would be no additional margin required for this position.

Regards,
Brian (Og)