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June 18, 2014

AAPL Butterfly After the Split

There has been more talk than usual about Apple Inc. (AAPL) before and now just after the split. Several traders have asked me about what type of AAPL option trade they can use if they think AAPL will rise to around $100 in a few short weeks. Truth be told, there is more than one option strategy that can profit. But an option trader should consider a directional butterfly spread particularly if he or she has a particular time frame in mind as well. Depending on how the butterfly spread is structured, the option trader can structure a high risk/reward ratio for the spread. Let’s take a look at this option strategy.

The long butterfly spread involves selling two options at one strike and then purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are considered to be the wings and the short options are the body of the butterfly. The option strategy objective is for the stock to be trading at the sold strikes at expiration. The option strategy benefits from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value and the lower strike call on a long call butterfly spread or higher strike put for a long put butterfly spread have intrinsic value.

As mentioned above, if an option trader thinks that AAPL will be trading around $100 in about three weeks, he can implement a long call butterfly spread with the sold strikes (body) right at $100. Put options could also be used but since the spread is being structured out-of-the-money (OTM), the bid/ask spreads of the options tend to be tighter versus in-the-money (ITM) options which would be the case with put options. The narrower the option trader makes the wings (long calls) the less the trade will cost but there will be less room to profit due to the breakevens. If the butterfly spread is designed with larger wings, the more it will cost but there will be a wider area between the breakevens.

At the time of this writing, AAPL is trading around $92. An option trader decides to buy a Jul-03 97/100/103 call butterfly for 0.15. The most the trader can lose is $0.15 if AAPL closes at or below $97 and at or above $103 at expiration. The breakevens on the trade are between $97.15 (97 + 0.15) and $102.85 (103 – 0.15). The maximum profit on the trade in the unlikely event AAPL closes exactly at $100 on expiration would be $2.85 (3 – 0.15). This gives this option strategy a 1 to 19 risk/reward ratio. Granted AAPL needs to move higher and be around $100 in three weeks but one could hardly argue about the risk/reward of the option strategy or the generous breakeven points of the spread.

This AAPL option trade may be a bit overwhelming for a new option trader to understand and there is more than one way to take a bite out of AAPL with a bullish bias. A directional call butterfly spread in this instance is just one way. A big advantage that the directional butterfly strategy may have over another option strategy is the high risk/reward ratio. The biggest disadvantage is the trader needs to be right about the time frame in which the stock will trading between the wings since maximum profit is earned as close to expiration as possible.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 27, 2014

Directional Butterfly

Many option traders use butterfly spreads for a neutral outlook on the underlying. The position is structured to profit from time decay but with the added benefit of a “margin of error” around the position depending on what strike prices are chosen. Butterflies can be great market-neutral trades. However, what some traders don’t realize is that butterflies can also be great for trading directionally.

A Butterfly

The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. This is usually implemented with all calls or all puts. The long options are referred to as the wings and the short options are the body; thus called a butterfly.

The trader’s objective for trading the long butterfly is for the stock to be trading at the body (short strikes) at expiration. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value; and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value. Maximum loss (cost of the spread) is achieved if the stock is trading at or below the lower (long) option strike or at or above the upper (long) option strike.

Directional Butterfly

What may not be obvious to novice traders is that butterfly spreads can be used directionally by moving the body (short options) of the butterfly out-of-the-money (OTM) and maybe using slightly wider strike prices for the wings (long options). This lets the trader make a directional forecast on the stock with a fairly large profit zone depending on the width of the wings.

To implement a directional butterfly, a trader needs to include both price and time in his outlook for the stock. This can be the most difficult part for either a neutral or directional butterfly; picking the time the stock will be trading in the profit zone. Sometimes the stock will reach the area too soon and sometimes not until after expiration. If the trader picks narrow wings (tighter strikes), he can lower the cost of the spread. If the trader desires a bigger profit zone (larger strikes), he can expand the wings of the spread and the breakevens but that also increases the cost of the trade. It’s a trade-off.

Final Thoughts

One of the biggest advantages of a directional butterfly spread is that it can be a relatively low risk and high reward strategy depending on how the spread is designed. Maybe one of the biggest disadvantages of a directional butterfly spread is that its maximum profit potential is reached close to expiration. But being patient can be very good for a trader…most of the time!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

January 9, 2014

Butterflies, Expiration, the Importance of Time and Christie Brinkley

One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade instruments. Remember that option premiums reflect the total of both intrinsic (if any) and extrinsic (time) value. Equities are not affected by the passing of time unlike many movie stars. Even though Christie Brinkley is still considered to be still quite attractive by many, her look is not the same as it was decades ago when she was a top model and cover-girl. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.

While this decay of time premium to a value of zero is reliable and undeniable in the world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins to race ever faster to oblivion. In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.

Some of the most dramatic changes in behavior can be seen in the trading strategy known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single legged strategy such as simply buying a put or a call to multi-legged strategies that include both buying and selling options in certain patterns.

To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the same strike price constructed together in the same underlying in the same expiration. It may be built using either puts or calls and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.

The butterfly has the interesting characteristic in that it responds sluggishly to price movement early in its life. For example in the first two weeks of a four week option cycle, time decay or theta is slow to erode. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes and the spread becomes increasingly subject to delta as a result of increasing gamma. It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week. Beauty is in the eye of the beholder!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring