So far in this series we’ve discussed many different types of butterflies (standard spreads, skip-strikes, and Christmas trees). Now I plan on applying some of them to everyday trading scenarios. For example, today’s posts explains how to use a standard butterfly to help a long call position gone bad. We’ll start with a standard butterfly as a “save” and eventually substitute in one or more exotic butterflies in its place. Understanding the concept is what’s important here.
 
Our example: DRYS (DRYSHIPS INC.)

Let’s imagine we bought the June 100 call on May 22nd and paid 4.60 with the stock at 92.17 . In the next five days (by May 27), the stock drops to 87.14, which means the June 100 call is now at 2.5 x 2.6 with 24 days to expiration. Clearly, this trade is not going your way. What can you do about it?

One route would be to sell at 2.50, take the loss and move on. That's always available; if this is your stop loss point think hard about selling and moving on.

Your other route might be to butterfly it, giving yourself a chance to make the money back without adding a lot of extra capital or risk. Here’s how it works.

Original long call:

DRYS at 92.17
Bought 1 June 100 call at 4.60
Stock drops to 87.14
Long call drops to 2.50

Butterfly it:

Buy 1 June 90 call at 5.50
Sell 2 June 95 calls at 3.80
= 2.10 net credit to the account

Already holding 1 June 100 call at 4.60

This position requires no additional margin and brings a 2.10 credit into the account that we didn’t have before (2 x 3.80 = 7.60 – 5.50). Adding in the 4.60 we already paid for the 100 long call, the total cost of the butterfly is 2.50 (4.6 – 2.10). That’s not great, considering the cost of the entire butterfly if we bought it today all as one trade would be .60 -- but bottom line, we were long a call to start and our forecast was wrong. Now our outlook has switched to something along the lines of: we don’t want the cheese anymore; we just want out of the mousetrap. If we just sold and moved on we would obviously receive 2.50, so a 2.10 credit does mean we’ve taken on .40 of additional risk (as opposed to just selling and getting out).

If we do get lucky and the stock finishes somewhere between 90 and 100, that’d decrease our loss even more. If we hit a homerun and the stock finishes right at 95 we would make 5 on the butterfly that we paid 2.50 for and be up a total of 2.50 on the entire trade.  Realistically, though, our hope is that the stock finishes at expiration within a 5 point range, between 92.50 and 97.50. This means we succeeded and got out of the trap with no loss on the entire trade. So we are risking an extra 40 cents to have that chance at breaking even.  

The new break-even and net risk

Again, our break-even points are 92.50 and 97.50. The net risk of the entire position is 2.50, starting with the long call which we bought for 4.60 and can now sell for 2.50, for a 2.10 loss.  Having turned the position into a butterfly, our total risk is now 2.50 (including the initial long call purchase) and we have a fighting chance.

A few closing points: obviously this move assumes we’re still bullish on DRYS. You should also keep your expectation realistic: the ONLY time a butterfly is usually close to the maximum payout is if the stock is right at the middle strike (95) upon expiration. If it makes the move back to 95 tomorrow the butterfly will not be close to worth 5 points. See this blog on butterlies for further explanation.

Why is it possible to butterfly?

The short answer: time and volatility are both on our side with this trade. With 24 days left until expiration, it’s possible to get a decent credit for a butterfly, as in our example. If it were the last week before June expiration the credit received to leg into the butterfly would probably not be that enticing. It’s also a good thing that DRYS is a volatile stock; its implied volatility on June ATM options is currently 74%. On a less volatile stock the credit would once again be a lot less enticing.

Next week…

Check back for more variations on this trade next week. We’ll also examine how the original trade changes as expiration approaches and see how well this trade set-up fares.

Regards,
Brian (Og)    

[Image: Old Tools by Svadilfari 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.

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