I’ve been on a big butterfly kick in recent weeks, and today’s post wraps up the series with a look at how you can use butterflies to address volatility in the markets.  

(If you’re just tuning in now, start with my posts introducing common b-fly strategies like long butterfly spreads, skip-strikes (aka broken-wing butterflies), and Christmas tree butterflies. We also reviewed several ways you can turn a losing long call position into a butterfly for another shot at breaking even (or even profiting) from a trade gone wrong, what I call a standard butterfly save, the Christmas tree save and the skip-strike save.)

Volatility example: Bear Stearns and JPMorgan

As we all know, the craziest day in the sub prime mortgage mess was the day it was announced that Bear Stearns (BSC) was going to be swallowed up by JPMorgan (JPM) for pennies on the dollar. This had ripple effects on markets across the world, but hit one particular stock extra-hard, Lehman Brothers (LEH), a competitor of both Bear Stearns and JPMorgan. To make things even more interesting, LEH was announcing earnings that very same week of this surprise merger announcement, which sent LEH’s implied volatility through the roof. (If you aren’t already familiar with IV, catch up on this concept in my blog series, “Why Do We Care about Volatility?” which starts here.)

This chart shows a weighted average of the 30-day implied volatility – that’s the yellow line labeled “IV Index Mean”, the white line is a the 30-day historical volatility.  That huge spike in mid-March marks the week for LEH, blowing away its previous all-time high for IV. The graph is a weighted average, the actual implied volatility of the front month (March) At-the-Money (ATM) options traded with an IV over 400% just before the earnings announcement on 3/18. This was because there was speculation that LEH might go the same route as Bear Stearns. What would’ve been the best strategy to play all this volatility, if you were so inclined? Let’s run through a few possibilities.

The obvious play when volatility is extremely high and you think it’ll come down is to sell the ATM Straddle (sell call and sell put with same strike price) - but this move is definitely not for the faint of heart. Also, your brokerage firm will require a large margin requirement to hold the position because the strategy has unlimited risk. Yes, with straddles you’re typically selling options with a LOT of premium in them, but if the stock does make the move the market is implying, you could easily lose the farm.

So what’s a less risky alternative? You could always sell the straddle and then buy some protection above and below your strike, just in case. If we do this, we’ve created a butterfly – sold the middle strike and bought the wings.

Here’s the logic behind using a butterfly for this play. You’re selling two options with a strike price close to the stock price, raking in some handsome premiums in the process. Usually the options with strike prices closest to the stock price contain the most “juice” or time premium. Ultimately you’re hoping time premium of the middle strike option dries up, dropping from its current high or at least coming back to more average levels. We then buy the cheaper – in terms of time premium - ITM and OTM options. These options limit our risk and provide some protection just in case the big move happens.

Mr. Pink’s volatility play

I know of a fellow who placed a fantastic volatility trade on LEH right around this time.  Let’s run through the true story of this trader – call him Mr. Pink – and his success with this trade.  

Since volatility had gotten so high, Mr. Pink was bearish on the stock and wanted to play his outlook without paying a lot for his strategy. He was also bearish on volatility. So he placed the following trade to reflect all those views:

LEH at 27.42 on 3/17/08
32 days to expiration
Buy 10 LEH Apr 35 puts at 12.49
Sell 20 LEH Apr 25 puts at 7.87
Buy 10 LEH Apr 15 puts at 4.00
= Net debit of .75

This is a 10-point wide butterfly that Mr. Pink paid 75 cents for, or 10 x 100 x .75 = $750 plus commissions. This trade gave him a 20-point wide range of profitability, with breakeven prices for the stock at 15.75 and 34.25. In other words, if LEH had stayed in this range his b-fly would have been profitable. If he just did the straddle (sold the 25 call and sold the 25 put) he would’ve brought in a lot of premium, but also given himself unlimited risk on the upside and downside.   

As you probably know Mr. Pink’s stock price forecast was wrong. Earnings on LEH were not half bad, and the stock bounced back to close on 3/18/08 at 46.49. Now for the fun part of the story. Even though Mr. Pink was off in his earnings prediction, he was correct in believing implied volatility would go down massively. As you can see in the graph above, it was not long before the IV index  moved from 200% to below 100% - more than a 100% drop in IV over a very short period of time.

So Mr. Pink sweated out the situation and waited. When the stock came down, to 36.80 on 3/31/08, his butterfly was trading for 1.50 and he sold. Here’s where his trade stood on 3/31:
 
Long 10 LEH Apr 35 puts at 3.10
Short 20 LEH Apr 25 puts at 0.90
Long 10 LEH Apr 15 puts at 0.20
Sold to close for net credit of 1.50

Even though he had been dead wrong on the direction of the stock, being right on his volatility forecast resulted in a 100% profit on the monies invested in to the butterfly. Not too shabby, eh?

The key here was timing. Since the April options still had 19 days to expiration on 3/31/08 the position retained its value even though the stock was not trading between the break-even points (15.75 and 34.25). If Mr. Pink used the March options the trade would’ve expired with the stock way above the highest strike and decline in volatility would not have helped at all. Butterflies are a very delta-neutral trade to start with, so with the large drop in volatility the buy-back of the 20 contracts with the 25 strike was less painful. The result was a profitable trade despite a wrong forecast on direction.

In summary…

Hopefully this blog series on butterflies has helped you come to appreciate the versatility of this strategy. While they’re not a basic strategy, butterflies can come in handy in a variety of situations.

If you have any final questions on butterflies, or better yet any specific examples from your own trading, bring ‘em on! This doesn’t have to be the end of the conversation on this rich topic.

Regards,
Brian (Og)

[Image: Butterflies Mosaico by Antonio Machado 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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Out of all the option strategies I like this one the best. Sometimes it would seem like with the complexity of these trades that you might lose sight of what it was you set out to do in the first place. Ever felt that happened to you? It would seem that you could create even more profit if you guessed right when you unwind the trade?

Thanks for this series Brian. Very informative and I learned a lot. Although I can't quite trade these on my account, it's good for me to build a solid understanding of these first before I actually jump into them.

Hello Snowman and locogmac,

I appreciated the comments. I have seen many people overtrade and get to a point where they don't know if they want the stock to go up, down or sideways. It is very important to try to control costs and ask the question "If I place this trade what do I want the stock to do after it is filled."

Regards,
Brian (Og)

Hello "G"

 I have tried the credit spreads for a while, really liked the idea of 100-300 percent interest on your money if you take the 10-30 percent in 20-30 days. I was trying to perfect the method to be able to repeat the system until I had a very high percentage of winning trades, then just adjust the amount of the trade to increase my income from the spreads. Over time I was hoping to replace my earned income with investment income and enjoy some free time. Well, I was using the probabilty calculator on your site and was doing trades on the OEX and wasn't putting on a trade unless it had an 85 percent chance of being profitable. Seemed like a good plan, but 6K later I am wondering what I did wrong. Do have any information or places where I might obtain some insight on this method, I know it will work if I can learn the in and outs like the back of my hand.

Thanks,

B Hatt 

Hello B Hatt,

The hardest thing about trading is to know when to get out of a losing trade and managing your risk. Unfortunately this market is rewarding the buyers of options not he sellers at this point. Implied volatility has been high all summer and it seems to continue to get higher. Unforeseen events will usually hurt the seller (short volatility) of options much more then the buyers (long volatility) and it is too bad that you started this plan of attack during one of the largest melt downs in the financial markets ever. I am usually a sell of options in general, but have done more long straddle type trades this year then I EVER have in the past.

I would suggest signing up for a mentoring service and finding like minded individuals to toss ideas off of. One thing about being in a group that sells options is they most are going to be in the same boat.

Regards,
Brian (Og)