In last week’s post I showed how you can turn a wayward long call into a potentially winning trade using a standard butterfly. In today’s post, we’ll show how to use a Christmas tree butterfly for the same “trade fix”.
(If you’re just now tuning in to my series on butterflies, make sure to check out my earlier posts on long butterfly spreads, skip-strikes (aka broken-wing butterflies), and Christmas tree butterflies.)
Quick recap: DRYS (Dryships Inc.)
So let’s review the example scenario from last week: let’s imagine we bought the June 100 call on May 22nd and paid 4.60 for it; the stock was at 92.17. In the next five days (by May 27), the stock dropped to 87.14, which means the June 100 call is now at 2.5 x 2.6 with 24 days to expiration. It’s obvious this trade is not going your way. What can you do about it?
As described last week, you could sell the call and move on, or turn the position into a standard butterfly and hope. There’s actually a third alternative: turn the long call into a Christmas tree butterfly. This approach will widen our sweet spot for breaking even – that’s the plus - but it’ll cost a little more to put on the trade – that’s the minus.. Specifically, that means when we leg into a Christmas tree butterfly, we’ll bring in less of a credit then when we legged into the standard butterfly last week.
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 – Christmas tree version:
Buy 2 June 85 calls at 7.80
Sell 3 June 90 calls at 5.50
Already holding 1 June 100 call at 4.60
= .90 net credit to the account
Again, like the standard butterfly “repair”, this new position requires no additional margin, and the net of the two legs brings in a .90 credit into the account (3 x 5.50 = 16.50, 2 x 7.80 = 15.60, 16.50 – 15.60 = .90). That 90 cents helps defray the initial cost of the 100 call. Starting with the 4.60 we already paid for the 100 long call, the total cost of the Christmas tree butterfly is now 3.70 (4.6 – .90). Again, this doesn’t look great compared to the cost of a Christmas tree butterfly if we bought it today all as one trade, which is 1.70. But since our long call isn’t moving as we’d hoped, this new trade has the potential to break even or profit under the new conditions.
If we just sold the call and moved on, we would obviously receive 2.50, so a .90 credit does mean we’ve taken on 1.60 of additional risk (as opposed to just getting rid of the long call).
The standard butterfly “save” vs. the Christmas tree
The Christmas tree “save” described above takes in a smaller credit (.90) versus the credit we received in last week’s standard butterfly (2.10). So why take this route?
Taking in less of a credit (compared to the standard butterfly) means more up-front risk for the Christmas tree, but it also provides a much wider sweet spot for breaking even at expiration. If the stock finishes at expiration somewhere between 88.70 and 96.30 the entire series of trades will break-even. Compare that to last week’s narrow break-even zone for the standard butterfly; there the stock needs to stay between 92.50 and 97.50 at expiration.
This illustrates a golden rule of options: if you increase your up-front risk, you’ll usually end up with the benefit of a wider sweet spot, and vice versa.
There’s another benefit of the Christmas tree over the standard butterfly that might justify accepting that smaller credit initially. The Christmas tree offers the chance of a bigger homerun if things go your way upon expiration. Specifically, if the stock finishes right on 90 at expiration, the Christmas tree butterfly should be worth about 10 (100 Strike – 90 Strike) which means the upside for the entire series of trades would be 10 – 3.70 or 6.30. Compare this to the standard b-fly, where the homerun was a maximum of only 2.50.
Keep these assumptions in mind
Like last week’s butterfly, the example above assumes we’re still bullish on DRYS. (This Christmas tree is actually a little less bullish than the standard one set up last week; Christmas-tree holders want the stock to go to 90 instead of 95, which is what the standard b-fly holders are rooting for.)
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 (90) upon expiration. If it makes the move back to 90 tomorrow the butterfly will not be close to worth 10 points. My post on long butterfly spreads will give you some good background as to why this is true.
In summary…
In a nutshell, here are the key differences between a standard butterfly and a Christmas tree as a “repair” on a long call gone awry:
1) Christmas tree brings in less initial credit than a standard b-fly – which means more risk overall
2) Christmas trees offer a wider sweet spot or break-even points for the new position
3) Christmas trees also offer more upside than a standard b-fly, if the stock expires at the middle strike
Next week if we are bearish I will give you a trade to consider using a skip strike…
Regards,
Brian (Og)
[Image: Rubik’s Cube by culture.culte 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.
