Doc Maher examines YoungCash's trade.
Iron Butterfly trades can be very profitable; however they usually have small profit ranges. Particular attention must be paid to the set up and management of these trades. In the following post I will explain how a specific Butterfly trade evolves as expiration approaches. You will also see the importance of understanding how the trade works and knowing in advance what can go wrong. For more on Butterfly trades, please see Play #21 in the online version of The Options Playbook located in TradeKing's Education Center. You can also begin an eight-part series by Brian Overby, starting with Butterfly series, part 1: long butterfly spread.
THE PLAY - IRON BUTTERFLY SPREAD
TRADE FORMATION
On August 1, 2008 at 10:49am, Community member YoungCash entered the following:
Strike A Put: Bought to open 1 WMT Aug $55.00 Put for $0.54
Strike B Put: Sold to open 1 WMT Aug $57.50 Put at $1.29
Strike B Call: Sold to open 1 WMT Aug $57.50 Call at $1.68
Strike C Call: Bought to open 1 WMT Aug $60.00 Call for $0.57
Butterfly spread entry: $1.86 net credit
Stock at entry: WMT near $57.90
Maximum gain: $1.86 net credit
Maximum loss: $0.64 (Strike B - Strike A - net credit)
Break-even points at expiration: $55.64 (Strike B - net credit) and $59.36 (Strike B + net credit)
On August 15 at 3:40pm, the trader closed one leg:
Strike B Call: Bought to close 1 WMT Aug $57.50 Call for $1.97
ALL-STAR COMMENTARY
I am going to focus on two issues: trade set up and trade management. Usually I do not spend much time on commissions (not included above). However for this trade I'll also be paying attention to transaction costs because this trade has four legs (options). The total cost needs to be considered.
An Iron Butterfly is basically the same thing as a Call or Put Butterfly except that it uses both puts and calls to form the spread. This is why it resulted in a credit. The butterfly is basically two vertical spreads, one bullish and one bearish with the short (sold) options at the same strike price. When we make an Iron Butterfly we make the bullish spread with puts. In this case it was long the August 55 put and short the August 57.50 put. The bearish spread was made up of a short August 57.50 call and a long August 60 call.
This results in the following P&L:
Click here for a larger image.
You will notice that I have put four curves on the graph. The dark blue represents expiration on August 15. The red represents the entry date of August 1. There are also curves for August 12 and August 14.
For this strategy to profit two things have to happen. Wal-mart stock has to stay within the break-even points and time has to pass. The closer it is to $57.50, the greater the profit. You can also see that the profit potential accelerates as we get closer to expiration.
Now look at the chart for WMT on August 1.
Click here for a larger image.
WMT has been in a narrow range since May. I have inserted the butterfly break-even lines on the chart to illustrate how narrow the profit range is. We can also see how far away the expiration date of August 15 is.
There are two things I want to point out here. First is that the range is very narrow. We know that as time passes if WMT is within the range the profit accelerates. On any day WMT may trade in a range of almost half the profit range. So we need to watch this one carefully because a profit could turn into a loss very quickly.
The second thing I want to point out is that this was done with only one contract of each option. The commission for each leg would be $4.95 +$0.65 = $5.60. To open this trade the cost is 4 X $5.60 = $22.40. It will cost another $22.40 to close it. Without commissions the max profit for this trade was $186 however if we include getting in and getting out the potential is now only $141.20. Including commissions, the break-even points become $58.91 and $55.80 and the max loss becomes $1.09. This points out that the cost of doing business for a four-leg strategy can be significant when trading single contracts.
Below is the chart of WMT up to August 15, options expiration.
Click here for a larger image.
Looking at the above chart it can be seen that on August 14, WMT was at the sweet spot of $57.50 for a brief moment. By August 15 expiration, WMT closes near the break-even point. So at one point on August 14, there was the possibility to close this trade for almost all of the potential profit.
Below is a chart of the bid and ask for this spread and WMT stock price over the duration of the trade.
Click here for a larger image.
This shows that the best exit was on August 14: to pay back approximately $1.05 of the original $1.86 credit when WMT was at $57.50. This would leave the trader with $1.86 - $1.05 = $0.81 ($81) profit not counting commissions. Unfortunately commissions would have amounted to $44.80 so the actual net would have only been $36.20. Of course if you trade more contracts it only add $0.65 for each one and that makes commissions less of an issue.
Looking at the P&L model chart this appears to be a little worse than the model predicted. Remember that the P&L is only a model. Actual bid-ask prices will vary from the model as the Implied Volatility of each option changes. The trader however didn't take this exit and on August 15 closed the short call for $1.97. This created a loss of $0.11 before commissions of $.224 + $0.056 = $0.28, for a total loss of $39. The rest of the options expired worthless. Not realizing how close he was to the maximum profit and how fast it could disappear lead to a loss instead of a profit.
I normally would not like to trade such a tight range. However Youngcash amazingly accurately predicted that WMT would stay in the range. It was actually in about as good a position as he could have hoped for, with WMT at $57.50 on the day before expiration. However he apparently didn't realize that this was about the best that could be achieved and didn't close the trade. This shows the importance of understanding how your trade works and what can go wrong.
Anyone interested in learning more can post a response on this blog or go to my website, http://www.docmahertrading.com/, and ask me a question via email.
"Income Trader"
Doc's previous posts: Throwing Good Money After Bad and Stay out of Trouble
For a list of recent All-Star blogs, please click here.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
