Floating With the Modified Butterfly Spread

December 3, 2013Uncategorized
Today I want to highlight an option trading strategyzs that relatively few traders ever
consider. This strategy is known as the “Modified Butterfly”. Since I am not entirely sure
who coined that phrase I will give credit to John Broussard, the developer
of www.OptionsAnalysis.com, the software I use for my own options, well, analysis.

(Please view my free “Finding Exceptional Opportunities” webinar

at http://go.mta.org/watch112013)

The “classic” butterfly spread involves buying one in-the-money call (or put) option, selling
two at-the-money call (or put) options and buying one more out-of-the-money call (or put)
option. An example of a “classic” butterfly spread appears in Figure 1, and the basic idea is
to be able to make money of the underlying security remains within a particular price
range.

Figure 1 – The “Classic” Butterfly Spread (Courtesy: www.OptionsAnalysis.com)

The problem with the “classic” butterfly is twofold:

1) If the underlying security makes a meaningful move in either direction you are out of luck.
For the record, I have found it just as difficult to predict when something “is not going to
move” as it is to predict when something “is going to move.” (In fact, early in my career,
whenever I would put on a “neutral” strategy such as a butterfly spread or a calendar spread,
it would invariably act as some sort of cattle prod to the underlying stock itself, and the
quietest, sleepiest, most boring stock in the world would suddenly burst from the gate like a
bat out of you know where).

2) Logistically you can run into the “inconvenience” of finding yourself long one in the money
option, short two in the money options and long one out of the money option on expiration
day. If you hold this position through the close of option expiration day you end up on the
following Monday with a position of short 100 shares of stock. Surprise! And not the
pleasant kind for the unsuspecting.

The Modified Butterfly is essentially an attempt to put the odds slightly in your favor and to
collect some option premium.

The Modified Butterfly (heretofore MB)

For the record, when the S&P 500 Index is above its 200-day moving average I prefer to
look for MB’s using put options and when the S&P 500 Index is below its 200-day moving
average I prefer to look for MB’s using call options.

Figure 2 displays an inputs screen from www.OptionsAnalysis.com for Modified Butterfly

spreads on 11/4/13. In a nutshell, we are:

-Buying 1 out-of-the-money put option

-Selling 3 puts at a lower strike price

-Buying 2 more puts at an even lower strike price

The ultimate goal of the trade we will find is for the stock to do anything expect decline
sharply (i.e., rally, stay relatively unchanged, or drop only a little) and to keep the premium
we collected when the trade was
entered.
Figure 2 – Modified Butterfly Inputs (Courtesy: www.OptionsAnalysis.com)

Figure 3 displays the output. This list is sorted by % Probability of

profit.

Figure 3 – Modified Butterfly Output Screen (Courtesy: www.OptionsAnalysis.com)

On the far right hand side you can see that a trade using SPY options has an 85%
probability of profit. However, two columns over to the left we see that the credit taken in on
this trade is only 0.3%. In a nutshell, we are risking $3,638 in order to make a profit of $12.
In my book, this is not enough profit potential to justify taking the risk.

Ideally, I want to see:

-Probability of Profit >= 75%

-Near P/L / Maximum Risk >= 5%

-Days to option expiration <=14

-No earnings announcement due prior to option expiration

In sum, I prefer to look for the opportunity to make at least 5% in 14 days or less with at least
a 75% probability of profit and no impending earnings announcement that could upend the
stock.

Further down in Figure 3 we find a trade using put options on AMZN that meets these
criteria. This trade risks $2,345 and takes in a credit of $155. This represents a 6.6%
potential return in just 11 calendar
days.

Figure 4 – AMZN Modified Butterfly (Courtesy: www.OptionsAnalysis.com)

Figure 5 – AMZN Modified Butterfly (Courtesy: www.OptionsAnalysis.com)

As you can see, this trade will make money as long as AMZN stays above $351.73.

A few things to note:

-The basic goal is for the stock to not plummet in which case we simply keep the credit taken
in when the trade was entered.
-However, because the downside risk is greater than the profit potential this IS NOT a “set it
and forget it” type of strategy. In other words, you need to think about in advance how you
will react and what steps you will take if the stock starts to fall hard and the trade starts to
accumulate a loss – especially if it reaches or exceeds the breakeven price.

-There is additional upside potential if the stock happens to be between the two lower strike
prices at expiration.

-The biggest risk for a trade like this is “the huge gap down.” Hence the reason I want to be
sure there is no earnings announcement due prior to option expiration. Likewise we are
looking for a trade with no more than two weeks left until expiration so as to minimize the
amount of time we are at risk.

As you can see in Figure 6, between 11/18 and 11/29 AMZN rallied sharply so all the legs of
this trade expired worthless and the initial credit was kept as a profit.

Figure 6 – AMZN stays above breakeven price of $351.73 (Courtesy: AIQ TradingExpert)

Summary

Traders and investors looking for an “income generating” strategy using options might do
well to take a closer look at the Modified Butterfly spread. If done right and managed
properly this strategy can generate a series of relatively small profits that accumulate nicely
over time.

The one “real world of trading” caveat to keep in mind is this: This is one of those strategies
where one unmanaged losing trade can wipe out a lot of small profits garnered along the
way. So the two keys to success with this strategy are:

1) Follow the guidelines listed earlier to focus on the best opportunities

2) Develop a “fail safe” plan for each and every trade so that you are prepared when the
“outlier” occurs (because eventually it will)

Jay Kaeppel

Use a combination of options to trade bottom-up reversals confidently

After a reversal move, trade can be initiated with same one higher strike Call but sell not one but
two lots of a three steps higher strike Call

Shubham Agarwal

Quantsapp Private

Trades taken after a confirmation of a trend reversal are more prudent. But more often than not
these reversal moves are generally unidirectional.

Trading in these situations can be tricky as we are in a trade set-up which is throwing a ‘left out’
feeling, while most participants are afraid of heights and may not have the courage to create
positions after a big move. The feeling is more pronounced when the reversal is from the bottom up.
This is because while pessimism could be fast and contagious, optimism is more often than not more
cynical.

Hence, bottom-up reversals like these, especially once established, are better traded with options.
Moves like these leave potential supports or the stop loss too far off. The only way to align trades to
those levels along with keeping the economic sensibility alive is by taking an options route.

A simple answer could be to buy a Call outright. The predefined maximum loss and slower
stings from an unfavourable move and more than proportionate gains with every increment does
make it a good choice. But it is a good idea only if the trade is for a few hours.

But when it is options, we are confronted with two problems. Reversals from bottom up are
generally accompanied with a drop in implied volatility, or risk premiums in options. This in turn
would reduce the option premium regardless of movement in price or time.

Another issue is that the market could decide to take a breather before the next leg up. The very
digestion exercise, or time correction, may reduce the premium in options while we wait for the
next leg up.

These two issues can be addressed easily once we resort to a combination of options instead of a
single option. Now these reversals may come at any time. Hence, we can resort to one of the two
solutions depending upon time to expiry.
Considering about 20 sessions to expiry, for the first 15 sessions it is always prudent to deploy an
Out-of-Money (OTM) Bull Spread. Buy one step higher strike Call and go two or even three steps
higher and sell that strike Call.

Keep the net premium outflow as maximum loss, while the strike difference less the net expense
should be the targeted profit. Since we have a buy and a sell it would take care of a drop in implied
volatility as well as time decay if any.

For the last five sessions or during expiry week, a slight alteration is needed. After a reversal move,
trade can be initiated with same one higher strike Call but sell not one but two lots of a three steps
higher strike Call.

This trade does have unlimited loss scenario in case of a violent move up, but considering the move
is already in place and speedy time decay in final days of expiry, it does seem prudent.

Profit can be booked as one is approaching the double sold strike. If the trade goes wrong, the loss
could be minuscule, turning the risk profile much more favourable.

Thus, instead of felling ‘left out’, use option combinations to trade confidently even if you missed
catching the bottom

How butterfly spread can be a much easier solution than options trade

Butterfly fits as a correct strategy, hence would like urge you to have Butterfly as a Strategy in
your option artillery as it could come very handy at times.

Shubham Agarwal

With a great deal of ease and convenience, Options do bring with themselves a certain set of
difficulties. These difficulties may make options unattractive as an instrument to trade in certain
situations. However, in such times I have always found shelter in an option strategy called Butterfly.

Let us discuss how certain peculiar situations can make Options unattractive to trade and how
Butterfly Spread can be an easy solution.

Situation 1: When the underlying has been through, or even worse is going through a turmoil of
constant downward spiral with sporadic pullbacks in between.

Here, I can quote an example of Yes Bank, just a few months back, when it collapsed from the levels
of Rs 300.

The drop pushed the implied volatility to around 100 percent, making Options super expensive.

In such situations, one wouldn’t want to Buy futures because of potential loss, while any bargain
hunting in Options may not be so effective due to:

a) The Options Premiums upfront are too expensive.

b) If and when the stock was to go higher, the risk premium in Option would reduce, not letting
option rise to its fullest.

Situation 2: Trading a stale consolidation is difficult as, even though we do have straight forward
strategies where one Sells both Call & Put to trade consolidation, we are running a huge risk of it
terminating into a big move.

Once again, a recent example of Nifty where a more or less 300 points consolidation for three
months, broke out of the range and pushed the index to a fresh high, in just a matter of days. In
stocks, this could be even more violent.

Situation 3: Every option would seem more expensive to trade and cost dear to hold when the
speed of time value decay is high. Typically, this would happen in the final days of expiry, when the
absolute time value is lower in Options but a day on day decay is very high.

One may attempt to create spreads by selling a higher call/ lower put option, but if you choose a
strike to sell too close, the profit gets limited, while choosing a farther strike, the premiums are too
small to short.

Situation 4: Finally, while handling a known event and trying to tackle certain fall in risk premiums in
the Options and thereby reduction in the Option premiums in totality.

I know the question this time is much bigger than the answer but these situations do present
themselves time and again. The solution to all these issues is resorting to Butterfly. Butterfly spread
can be created with the involvement of 3 strikes (for example 100,110,120) of same Expiry and same
Option type (for example Call), where we Buy 1 Lot 100 Call + Sell 2 lots 110 Call + Buy 1 Lot 120 Call.
There could be a variation of all Puts instead of Calls.

The variations are only to accommodate for liquidity otherwise involving same strikes do all Call/ all
Put, both will give the same pay-off.

Pay-off: Maximum Profit with expiry @ centre strike, Max Loss beyond the 2 strikes Bought Max
Profit = Strike Difference – net premium paid, Max Loss: net Premium Paid.

Now let’s see how Butterfly Spread is a solution to all the aforementioned situations:

1. For highly volatile stocks, Butterfly with initial outflow too low could be the best solution, because
if the positional view turns right one gets a fairly favourable reward for the limited risk taken.

2. For stale consolidations, one may choose centre strike close to the current market price, in case of
March expiry, like breakout in Nifty, the losses are predefined and limited to net Premium paid.

3. Choosing Butterfly in the final week of expiry can save us from an unlimited loss profile, as well as,
help us in creating a trade with the least possible cost.

4. As far as events are concerned, having equal quantities of bought and sold options would take
care of the drop-in risk premiums at the same time as mentioned in the first point, keeping the cost
lower.

To sum up, these were some situations where Butterfly fits as a correct strategy.
Hence, I would like to urge you to have Butterfly as a Strategy in your option artillery as it could
come very handy at times.

The author is CEO & Head of Research at Quantsapp Private Limited.

Deploy low risk Call Butterfly Spread strategy on Nifty in truncated week'

Option writers were seen placing bets on either side to take advantage of the time decay. The
Nifty PCR open interest wise stands at 1.54, keeping the room open for the upside

Future data of Indices depicts short in Bank Nifty whereas long unwinding was seen in Nifty for the
week. With the onset of Q4 results, IT stocks were under limelight as pullback was seen both
in TCS and Infy towards their important Put strike of 2,000 and 730, respectively.

As results were announced after-closing on April 12, the impact could be witnessed on April 15.

The Nifty options data saw monthly 11,500-11,600 Puts providing strong support and prices saw a
rebound, higher end 11,800 now acts as an immediate vital resistance with Call OI of 2.2 mn shares.

Weekly Nifty range gets narrower to 11,600-11,700 with an early indication of 11,700 Call writers
squaring off seen at end of April 12 session.

Considering coming week being truncated with only 3 working days, option writers were seen
placing bets on either side to take advantage of the time decay. The Nifty PCR open interest wise
stands at 1.54, keeping the room open for the upside.

With uncertainty prevailing over election outcome, Nifty May expiry implied volatility saw an uptick
resulting in a spike in India VIX by 260 bps to 20.99.

With Nifty future taking support near its gap area and Nifty spot prices forming multiple bottoms at
11,550 and reversing from lows reflect bull strength.

Further placement of Put writers at 11,600 with an unwillingness to cover shows positive bias in the
market. Thus bullish strategy is advisable. Considering truncated week, low-risk strategy Call
Butterfly Spread is recommended.

Call Butterfly Spread is bullish to rangebound strategy that offers decent risk-to-reward at low cost.
In this strategy, we need to buy 1 ATM Call, sell 2 OTM Calls near the target level and Buy 1 further
OTM call to hedge the risk.

Maximum profit in this strategy is at Call written strike. As theta decay is fast in weekly options, it is
idle for deploying Call Butterfly Spread.
What are Back Ratio & Back Ratio Spreads and how to use them in times of uncertainty

Back Ratio Spreads is an option strategy where one would Sell the Call or Put close to the current
market price of the underlying and Buy 2 Lots of Higher Call/ Lower Put.

Back Ratio

In an attempt of continually reshaping the options trade accounting for the temporarily changing
state of affairs especially in the options market, let us see how Back Ratios can help and how should
they be deployed.

So, the case here is that upcoming event getting closer is bringing along with itself incremental
amount of excitement, which gets translated into higher implied volatility which in turn keep making
Options more and more expensive.

The issue is this rising premium regime is an open secret that every one knows so the increments in
premium (not led by directions, of course) are so systematically moderate and starts its course so
well in advance due to the entire no arbitrage theories and market efficiency phenomenon that it is
next to impossible to gain out of it.

On the other hand, the problem that this ever-rising state of volatility brings along is the sheer
expensiveness of the Options premiums. This makes trading single options rather unattractive. Just
to give an example, think of trading YES Bank just a few months back right after the stock
plummeted. Options that typically were trading at 4-5 percent of underlying were now trading
anywhere close to 10-12 percent premium.

The only difference here is that with YES Bank it was taking cues of upcoming volatility as an impact
of a past event, while here we are taking cues from an upcoming event.

One of the ways to tackle these fat premiums is via Back Ratios. In normal times this may not be a
preferred strategy on the list but its apt when the implied volatility is in a rising mode.

Back Ratio Spreads: This is an option strategy where one would Sell the Call or Put close to the
current market price of the underlying and Buy 2 Lots of Higher Call/ Lower Put. This is the trade
which comes into play where we have a long month ahead of us before the event and the premiums
are getting fatter.

The trade requires us to have movement of sizable proportions in few days. The issue with these
movements is a Single Option with Fat premium would impose a large loss, while the Back Ratio
would have compounding impact of 2 Options out doing the one Short Option.

Benefit: If there is a move in favour, we make money while if things do not work out and no matter
how lethal is unfavourable move the losses are super small or at times there could be a profit from a
huge unfavourable move.

Caution: This strategy helps gaining out of direction as well as rise in implied volatility but the
drawback is the its heavily negative on Time Value hence only deploy in the first three weeks of the
expiry that too with reducing time stop loss of 5, 4 and 3 Sessions as the expiry gets closer.

The absolute returns from Back Ratios are not a handsome as a single Call but the Reward to Risk
equation is favourable. Hence, Back Ratios may not be the staple diet or your go to strategy every
time but when Time is ample and Implied Volatility is rising Back Ratios could come in very handy.

Open Interest: A tool to put market expectations into perspective

The Reduction in both Price and Open Interest could be labeled as Long Unwinding and on the
flipside of the same logic, Increment in Price with Reduction in Open Interest could be seen as
Short Covering

-We all know Futures and Options, or for that matter, any derivative instrument would actually sum
up to have a zero-sum pay-off, considering there is a Long for every Short. However, in an attempt to
make these bets, we do find traders like you and me, we end up painting a picture of our mood in
totality.
Today, let us have a look at one such data point and try to gauge if we can, some sort of directional
perspective on the underlying. The data in analysis would be that of Open Interest and the subject
matter of such observation would be Futures.

Open Interest, as we all know, is nothing but accounting of total number of contracts outstanding as
on that time in any particular instrument. Having said that, unlike volumes, every new Buying and
Selling may not account for fresh Open Interest.

Meaning, A Buys instrument X, B Sells instrument X and one lot of open interest is created. Now with
the next transaction, 3 things can happen:

-C wants to Buy one lot of instrument X, and A Sells it to C. This accounts for an additional
transaction with the Open Interest remaining the same as no new contract was created.

-C wants to Buy one lot of Instrument X and D comes and Sells instrument X. Thereby, now having 2
transactions between 4 parties and a creation of yet another contract. Open Interest turns 2.

-B who earlier sold wants to Buy back instrument X and A agrees to Sell it. Here, the new transaction
takes place between the same parties squaring off their original positions. This would lead to an
unwinding of that 1 lot open interest, making Open Interest Zero.

Out of all these 3, most of the transaction would fall under situation #1. But situation #2 & #3 are
the ones which we are more interested in. Situation #2 especially where there was open interest
addition. This is helpful is because it is indicative of the fact that there is additional trading interest in
the underlying with fresh directional expectation. Once we understand this bit of Open Interest data
creation, we can now go on to associate Price to the Creation and Unwinding of open interest, which
will help us have 4 different combinations of derivatives data.

Now considering the instrument under question is Futures. Let us see what each of these four
combinations imply.

If Price is Up and Open Interest has also Increased, isn't it safe to assume that the Buyer had lower
bargaining power in creating positions? In other words, if I am expecting Stock X @ 100 to go up to
110, I wouldn't mind Buying it at 101 as at this moment the position creation is more essential than
hunting for bargains.

This means that whenever we see Price Up and Open Interest added, it could be inferred as
additional bullish bias added into the stock. Similarly, with the same logic, the setup in the other way
around also can be justified. Whenever we see Price Down and Open Interest added, it could be
inferred as additional bearish bias added into the stock.

Now for the unwinding, here the open interest is in a reduction mode. Alongside it, if we see a
reduction in Prices, could actually mean that pressure from sellers was higher. Now, who would be
selling to unwind their position? The answer is, one who has existing Longs.

Thus, we could conclude Reduction in both Price and Open Interest could be labeled as Long
Unwinding and on the flipside of the same logic, Increment in Price with Reduction in Open Interest
could be seen as Short Covering.
Out of personal experience, this data alone has never been enough to base my trades on but
analyzing the futures Open Interest data has always given me timely insight into the consensus
getting built into the underlying.

What we discussed today may just be the tip of the iceberg in terms of making sense of derivatives
data but make a start with this piece of data and it would open up deeper insights which if not help
take a trade would definitely help filter a good trade out of many available.

BUTTERFLY SPREAD COURSE

Welcome to Part 1 of the Options Trading IQ Butterfly Course. Today we’ll be introducing the
butterfly and discussing some of the basics.

Butterflies are a well know option strategy, but they are commonly misunderstood and often traded
poorly by novices. After doing some research I realized there isn’t a great deal of information around
regarding butterflies. It’s not one of those really popular strategies like iron condors or covered calls
where there is almost an overabundance of information. The information available is spotty and very
disjointed. With this course I want to create the ultimate, one-stop shop guide to the butterfly
strategy. So, are you ready to come along for the ride?

A butterfly is a neutral (generally), income oriented strategy. It is a limited risk and limited profit
trade, but on a typical butterfly trade, the profit potential is higher than the potential loss. Butterfly
spreads involve 3 different option strike prices, all within the same expiration date, and can be
created using either calls or puts. A typical butterfly would be constructed as follows:

Buy 1 in-the-money call

Sell 2 at-the-money calls
Buy 1 out-of-the-money call

The in-the-money and out-of-the-money calls are placed at an equal distance from the short strike.
A butterfly trade is entered for a net debit which means money will be deducted from your account
once the trade is placed. This is the maximum amount that you can lose from the trade. The
maximum profit is calculated as the difference between the short and long calls less the premium
that you paid for the spread. For example if you had the following butterfly spread:

Long 1 June $95 call @ $5.00

Short 2 June $100 calls @ $2.50
Long 1 June $105 call @ $1.00

The total net debit to enter this trade is $1 which means the maximum profit is $4. This is calculated
as the difference in the strike prices from the short to long strikes ($5) less the premium paid ($1).
The potential return on investment is 400% and this would occur if the stock closed exactly at $100
at expiration. You should be aware the achieving the full 400% return is extremely unlikely, but more
on that later.
The breakeven points for a butterfly are calculated as follows:

Downside breakeven = lower call PLUS premium paid ($95 + $1) = $96

Upside breakeven = higher call LESS premium paid ($105 – $1) = $104

In this example, the maximum loss will be incurred if the stock closes at $96 or below and at $104 or
above. You can see this on the diagram below.

The Butterfly Payoff Diagram

As you can see above the butterfly payoff diagram or expiration graph has a tent like shape with the
potential for very large profits around the short strike. It’s important to keep in mind that it’s very
unlikely that you would ever achieve the maximum profit. In fact, some traders say, that you should
basically ignore the top one-third of the butterfly expiration graph as it unlikely and unrealistic that
your trade will finish in that area. The other problem with the top third of the butterfly graph is that
profits will fluctuate wildly even with only small movements in the underlying due to the high level
or short gamma. The closer you get to expiry, the higher the gamma will become, and the more your
profits will fluctuate.

A good aim for a butterfly trade is to make a 15-20% return on capital at risk.

Should You Use Calls or Puts?

Butterflies can be traded with either calls or puts, it doesn’t really matter. You can also trade an iron
butterfly which uses BOTH calls and puts. An iron butterfly is basically a combination of a bear call
spread and a bull puts spread. Generally speaking, traders will use calls for neutral and bullish
butterflies and puts for bearish butterflies but there is no real hard and fast rule. Iron condor traders
may prefer to trade iron butterflies. Advanced traders might look at the relative skews of calls to
puts. If puts are much more expensive due to significantly higher levels of implied volatility, they
may prefer to use puts, but generally speaking the payoff is going to be very similar whether you use
calls, puts or both.

Some Things to Keep In Mind When Trading Butterflies

Butterflies are a commission intensive strategy as you are trading 4 contracts each time you enter a
trade, and 4 contracts when you exit a trade. As most brokers charge transactions fees on a per
contract basis, this can soon add up and should be taken into account when evaluating whether
butterfly spreads are right for you.

The greeks will be discussed in detail shortly, but basically butterflies are short volatility, short
gamma and long theta. Gamma is a very important aspect to be aware of when trading butterflies,
particularly as you get closer to expiry.

When trading multi-legged options strategies as one order, the bid-ask spreads can be significant
and therefore make it difficult to initiate a trade for a decent price. If you choose to enter the 3 legs
individually you run the risk of the market moving against you before having the entire position
opened.

You can move the center strike of a butterfly slightly in-the-money or out-of-the-money to reduce
the cost, however this gives the trade a directional bias. Sometimes this can be a good thing and we
will discuss directional butterflies in detail shortly.

Why Trade Butterflies?

Unlike other options strategies such as iron condors and credit spreads, butterflies are very dynamic
and can be traded for a variety of different reasons with different goals in mind. Some reasons to
trade butterflies include:

* Income – Butterflies are a great way to generate income from stocks you think are going nowhere
in the short term. This can contribute to overall portfolio returns in flat markets.

* Non-Directional – In their simplest form, butterflies are delta neutral or non-directional trades.
Trying to pick the direction of stocks or the overall market can be stressful and expensive. Delta
neutral butterflies can be set up with strict rules to take the guesswork out of trading.

* Hedging – Market makers and advanced traders often use directional butterflies as a short term
hedge on positions that are moving against them. Centering the profit tent of a butterfly around a
strike that is under pressure in another trade (such as a credit spread) can be a great way to control
risk and allow you to keep the original position open for a few more days. Sometimes that is all you
need for a trade to move back in your favor. At that point you can then remove the butterfly hedge
and stick with your original trade. Long term out-of-the-money put butterflies can also be a much
cheaper method of portfolio protection than pure long puts.

* Low Maintenance – Butterflies are sometimes called “vacation trades” due to their low risk and
need for only very infrequent monitoring. Butterfly trades are generally very slow moving early on in
the trade. They can get a little exciting and volatile as they approach expiry and are within the profit
tent though.
That’s it for today, some fairly basic stuff covered but in the next session we will get in to some of
the meaty details when we look at how to enter trades in your brokerage account, how to set profit
targets and stop losses and how to choose strike widths.

Today, in Part 2 of the Butterfly Course, we will get into some more juicy details, specifically how to
enter trades in your brokerage account, how to set profit targets and stop losses and how to choose
strike widths. Let’s get stuck in to it.

Entering Trades In Your Brokerage Account

The easiest way for beginners to enter a butterfly is to create a single order in your broker’s option
trader module. However, butterflies can be tricky to get filled on when entering as one order. In
addition, the bid-ask spreads can be quite wide depending on the underlying stock that you are
trading. You can see below, 3 separate butterfly spreads. SPY being the most liquid of the 3 has the
tightest of the 3 spreads with only $0.08 between the bid and the ask. AAPL is has a slightly higher
spread on both a dollar and percentage basis with a spread of $0.69. RUT is the least liquid of all
with a massive difference between the bid and ask prices on both a percentage and dollar basis. The
dollar spread of $1.70 is very high; you might be able to get filled close to the mid-point, but you run
the risk of some slippage here if you are looking to trade butterflies on RUT. Definitely something to
keep in mind.

Entering Butterflies As A Debit Spread And A Credit Spread

If you’re having trouble getting filled on you single butterfly order, or you don’t like the look of those
bid-ask spreads, another way to enter your butterfly is as a debit spread and a credit spread. After
all, that’s all a butterfly is – a combination of a debit spread and credit spread.

Looking at our AAPL example, you would buy 1 AAPL June 21 $425 – $450 debit spread and sell 1
AAPL June 21 $450 – $475 credit spread. You’re looking at a bid-ask spread of $0.40 on the debit
spread and $0.16 on the credit spread. The total spread is less than our butterfly trade ($0.56 v
$0.69). You will also find it easier to get filled on two vertical spreads rather than one butterfly
spread.

The SPY spreads are fairly similar which makes sense given the huge levels of liquidity. Trading the
two vertical spreads has a total bid-ask spread of $0.09 compared to the single butterfly order at
$0.08.

The bid-ask spread on RUT is similar to AAPL in that it is slightly lower when entering at two vertical
spreads – $1.50 v $1.70. So for RUT you will find it easier getting filled using the two vertical spread
method.

When starting out with butterfly trades, it might be prudent to start trading highly liquid stocks and
ETF’s. SPY is one of the most liquid instruments in the world, so this would be a good place to start
for your butterfly trades. Try entering your trades via the two methods presented above and see
which method is easier to get filled. Once you become familiar and confident with entering the
trades and getting filled, you can then move on to trading other instruments and trading different
variations of the butterfly which we will discuss shortly.

How to Set Profit Targets and Stop Losses

When trading butterflies it is easy to get caught up in the hope (a very dangerous word in the stock
market) of achieving the full profit as shown in the payoff diagram. As mentioned previously, it is
extremely unlikely that you will achieve the full profit potential on a butterfly trade. A good aim for a
butterfly trade is a 15-20% return on capital at risk and the maximum acceptable loss should also be
around the 15-20% level. As with most income strategies you need to make sure when you have a
losing trade, you are not losing much more than the typical gain you are making from your winning
trades. Typically you should set a hard stop loss at 1.5 times the average gain. So if you are generally
making 15% on your butterflies, your maximum loss on any trade should be around 20-25%.

When taking profits, you can also set time based rules for taking profits. For example, if you have
made 10% within 10 days of opening a 35 day trade, that might be a really good place to take profits
even though your initial target was 15%. Achieving a healthy 10% return that early in a trade is a
great thing and sometimes it’s best to just say “thank you very much” and wait for the next
opportunity.

How to Choose Butterfly Strike Widths

Where you place your wings (which are the bought options in a butterfly spread), is a matter of
personal preference and will also depend on which instrument you are trading. How far apart you
place the wings, will determine how “fat” or “skinny” your butterfly payoff diagram looks. Spreading
the strikes out a long way can increase the profit potential and move the breakeven points in your
favor, but it comes with the cost of having to allocate more capital to the trade.

Let’s take AAPL for example. In the following three diagrams, you will see three different butterfly
trades for the same expiration date, all centered around the at-the-money strike of $450. First we’ll
look at a trade with 10 point wide wings, then 25 points and then 50 points.

AAPL 10 POINT WIDE BUTTERFLY

Date: June 4, 2013

Current Price: $446

Trade Set Up:

Buy 5 AAPL June 20th, 440 calls @ $16.00

Sell 10 AAPL June 20th, 450 calls @ $10.25
Buy 5 AAPL June 20th, 460 calls @ $6.05

Premium: $775 Net Debit.

AAPL 25 POINT WIDE BUTTERFLY

Date: June 4, 2013

Current Price: $446

Trade Set Up:

Buy 5 AAPL June 20th, 425 calls @ $27.50

Sell 10 AAPL June 20th, 450 calls @ $10.25
Buy 5 AAPL June 20th, 475 calls @ $2.44

Premium: $4,620 Net Debit.

AAPL 50 POINT WIDE BUTTERFLY

Date: June 4, 2013

Current Price: $446

Trade Set Up:

Buy 5 AAPL June 20th, 400 calls @ $50.90

Sell 10 AAPL June 20th, 450 calls @ $10.35
Buy 5 AAPL June 20th, 500 calls @ $0.49

Premium: $15,345 Net Debit.

Rather than discuss the three variations individually, I feel it’s best to present some of the key
information in table format so we can compare.

Looking at the above table, you can see that there are some obvious differences between the three
variations. All of them are more or less delta neutral, the 50 width butterfly has a slightly higher
delta, but it’s still fairly neutral. The big differences come in when you look at the capital at risk (max
loss), the potential return and the Theta-Vega exposure.

The narrower butterflies require much less capital and therefore have a lower maximum loss. The
potential maximum gain compared to the maximum loss is much higher for the narrow butterflies.
The trade off with this is that the wider butterflies have a much higher range and therefore
likelihood of profit.

The Vega exposure is another key difference; you can see that the 50 width butterfly has a Vega
exposure that is 10 times higher than the 10 width butterfly. If you have a strong view that implied
volatility is going to fall, you are potentially better off trading the 50 width butterfly.

The Theta to Vega ratio for the 10 width butterfly is almost one to one whereas the ratio for the 50
width butterfly is just over 50%. A higher Theta to Vega ratio gives you more capacity to withstand
rising volatility. An as example, if volatility increases 1 percent on day one of the trade, the 10 width
butterfly with lose around $24, but will gain around $21 in Theta decay which basically offsets the
loss from increased volatility. The 50 width butterfly will lose $224 dollars from Vega and only gain
$130 from Theta decay.

Based on the all of the information presented above, I think the 25 width butterflies present the best
scenario.

USING STANDARD DEVIATION TO SELECT BUTTERFLY WINGS

Another consideration on where to place the wings is to see what a one standard deviation move in
the underlying instrument would look like. To calculate one standard deviation you take price x
volatility x the square root of the days to expiry / 365. If that formula seems complex, don’t worry,
I’ve created a simple to use spreadsheet which you can download
from http://www.optionstradingiq.com/standard-deviation-calculator/.

While the stock market is filled with statistical anomalies, generally a stock will stay with a range of
plus or minus one standard deviation about 68% of the time. So if you place your wings around one
standard deviation away from the current price, you will have a winning trade roughly 2 times out of
every 3. Of course, nothing is guaranteed in the stock market!

Using the AAPL example above and my standard deviation calculator, you can see that a one
standard deviation move over the course of this trade would put AAPL at either $472 or $420, so our
25 point wide butterfly looks like a good option, or we could even stretch that out to 30 points in
order to get our strikes around the one standard deviation mark.

There’s a lot of information to digest in today’s lesson, go back and read everything again if you feel
you need to. In the next lesson, we’ll look at a couple of different methods for legging into
butterflies to increase profits.

In Part 3 of the Options Trading IQ Butterfly Course, we’ll be looking at various methods for legging
into butterfly trades in order to increase profits.

How to Successfully Leg Into a Butterfly

Legging into a butterfly spread should only be attempted by advanced traders or those with at least
one years’ experience of trading butterflies. Legging into trades involves more risk because you are
basically taking a directional view prior to implementing the full butterfly spread. If that directional
view turns out to be wrong, you are behind the 8-ball from the start, and it’s a struggle to work your
way back. That being said, if your directional opinion is correct, you can end up with a substantial
profit or even risk free trade that you can ride into expiration. We’ll take a look at a couple of
different ways to leg into a butterfly – using a long call, using a debit spread and using a credit
spread.

First, let’s look at a standard butterfly so we can compare:

Date: July 4th 2013,

Current Price: $265

Trade Details: AMZN Butterfly Spread

Buy 1 AMZN July 19th $265 call @ $10.00

Sell 2 AMZN July 19th $275 calls @ $5.75
Buy 1 AMZN July 19th $285 call @ $3.10

Premium: $160 Net debit

LEGGING IN WITH A LONG CALL

Suppose you were bullish on AMZN and decided to leg in using a long call. On June 4th, with AMZN
trading around $265, you buy a July 20th $265 call option for $10.00. Two days later, AMZN has
rallied to $275. You then sell two July $275 calls and buy one July $285 call. Here are the details of
the trade:

Date: July 4th 2013,

Current Price: $265

Trade Details: Legging in to a butterfly with a long call

Buy 1 AMZN July 19th $265 call @ $10.00

Two days later, AMZN has risen to $275.

Date: July 6th 2013,

Current Price: $275

Trade Details: Completing the butterfly

Sell 2 AMZN July 19th $275 calls @ $11.10

Buy 1 AMZN July 19th $285 call @ $6.70

Premium: $550 Net Credit

You now have a riskless butterfly where you will make at least $550. Even though you are selling
more options than you are buying with the second trade, your broker will realize you already have
one long call so this will not be considered a naked trade. Here’s how the payoff diagram looks, you
can see that this trade will make at least $550 no matter where AMZN finished at expiry

Of course, this is all very easy in hindsight and much harder to do in practice, but you can see that
legging in to butterflies can be very lucrative if you can get your timing right. Imagine for example,
that you were legging in to this trade, but AMZN dropped $10 rather than rising $10. At that point
you would either have to close out your long call for a loss, or if you complete the butterfly, you
would have a position where the majority of the tent was below the profit line.

LEGGING IN WITH A DEBIT SPREAD

Legging in to a butterfly with a debit spread follows a similar logic to using a long call, but the risk
and delta exposure is much lower. Taking our previous AMZN example, let’s take a look at how this
might work.

Date: July 4th 2013,

Current Price: $265

Trade Details: Legging in to a butterfly with a bull call debit spread

Buy 1 AMZN July 19th $265 call @ $10.00

Sell 1 AMZN July 19th $275 call @ $5.75

Date: July 6th 2013,

Current Price: $275

Trade Details: Completing the butterfly with a bear call credit spread

Sell 1 AMZN July 19th $275 call @ $11.10

Buy 1 AMZN July 19th $285 call @ $6.70

Premium: $15 Net Credit

By legging in to the butterfly with a debit spread we have still managed to create a risk free trade,
although our profit will be smaller than legging in with just a long call. Keep in mind though that our
risk on the second trade is lower. We only had to use $425 to create the second position rather than
$1,000.
Let’s also compare the greeks of the two methods. You can see that there is a much larger exposure
to both Delta and Vega when using the long call method. A slightly less significant consideration is
the faster Theta decay, but considering you would only hold the long call for 1-2 days before
completing the butterfly, this should not be your primary concern. The long call method of legging in
has higher potential profits, but as you would expect, along with that come higher risks.

LEGGING IN WITH A CREDIT SPREAD

Another method for legging in to a butterfly would be to use a credit spread. As the previous
examples have been on a rising stock, let’s take a look at a falling stock – GLD

Date: July 4th 2013,

Current Price: $135

Trade Details: Legging in with a bear call credit spread

Sell 1 GLD July 19th $134 call @ $4.25

Buy 1 GLD July 19th $137 call @ $2.81

Two days later, GLD has fallen to $134.

Date: July 6th 2013,

Current Price: $134

Trade Details: Completing the butterfly with bull call debit spread

Buy 1 GLD July 19th $131 call @ $5.15

Sell 1 GLD July 19th $134 call @ $3.35

Premium: $36 Net Debit

This trade example, doesn’t quite give you a risk free trade, but $36 is still very low and gives you a
potential profit of $264.
Reasons with you might want to leg in with a credit spread rather than a debit spread include:

* Decreasing Volatility – If you think volatility will decrease, initiating the trade with a credit spread
will give you a short Vega exposure

* Time Decay – Even if it is just 1-2 days, initiating with a credit spread means time decay is working
in your favor rather than against you as with a debit spread.

If you are bullish on a stock, you can also leg in using a bull put credit spread. I won’t go through the
details as I think you get the idea. Basically you enter a bull put spread to start, then once the stock
has risen, you buy a bear put spread.

BUTTERFLY COURSE PART 4 – TRADING RULES

In part 4 of the Butterfly course, we will be looking at setting up trading rules including when to
enter, exit and adjust trades.

There are many variations when trading butterflies, but for now let’s look at a standard delta neutral
butterfly and come up with some trading rules.

UNDERLYING INSTRUMENTS

The underlying instrument on which to trade butterflies is a key consideration. Highly liquid stocks
and ETF’s will help reduce slippage due to narrower bid-ask spreads so this should be the first place
to look for trades. The other advantage of ETF’s and Indexes are that you don’t have to worry about
earnings reports. If a stock is reporting earnings during the life of your butterfly trade, it is likely to
have a huge move, not something you want on a delta neutral trade. Most indexes are European
style so there is no risk of early assignment which can be a problem for butterfly traders. This allows
you to hold butterflies on indexes until closer to expiry and potentially achieve higher profits.
Indexes such as SPX, RUT and NDX are great targets for butterflies as well as ETF’s such as SPY, GLD
and DIA.

For individual stocks, you want to be looking for stocks that are trading for at least $75 and
preferably over $100. The distance between strike prices is more favorable and you can trade fewer
contracts which help keep trading costs down. Stocks such as AAPL, AMZN, GOOG and IBM are good
examples just remember to keep an eye on earnings releases.

TIME TO EXPIRY

For butterflies you generally want to be looking at the monthly expiration cycle, particularly for
beginners. Weekly options can be very risky no matter which trading strategy you are using. The
sweet spot is anywhere from 30-45 days to expiry but some traders may also go out as far as 60
days. The minimum time to expiry should be no less than 30 days though. There is a time and place
for trading weekly butterflies, but we will discuss that shortly.

VOLATILITY LEVELS

We know that butterflies are short volatility trades and that a spike in implied volatility will hurt us,
so it makes sense to enter butterflies when volatility is high. However, volatility can be a double
edged sword. Sometimes high volatility breeds more volatility. Also if you enter a butterfly when
volatility has spiked, that generally means the market has sold off sharply. Reversals from those
selloffs can be equally as sharp which could mean the price blows right back through the upper
strike of our butterfly. Ideally what we want is a period of steady or slightly declining volatility over
the course of the trade, particularly during the first 10-15 days. It therefore makes sense to look for
an ideal range of volatility levels. You don’t want to trade butterflies when volatility is at extreme
lows or extreme highs.

One way to look at volatility is to look at the range over the past 6 to 12 months and then disregard
the top and bottom quarter. Let’s say implied volatility for the instrument you are looking at has had
a range between 10 and 30 over the past 6 months for a range of 20. The top quarter of that range is
between 25 and 30 and the bottom quarter is between 10 and 15. Now you have an implied
volatility range of 15 to 25 with which to work. Entering trades when volatility is within these levels
should give you a better chance of achieving success.

RULES FOR LEGGING IN

We have previously looked at different ways to leg in to butterfly trades and this is something you
can incorporate into your butterfly trading plan. There are many different ways to leg in and many
different rules you could set up. A lot of this comes down to personal preference and risk tolerance.
Some trades will not want to leg in at all due to the directional risk, while others may be happy with
that exposure.

For traders who want to leg in, your trading plan should include guidelines on when and how to do
it. The how indicates the method of legging in. Will you use long calls and puts, debit spreads or
credit spreads? When you leg in to a butterfly could be based on certain technical indicators or chart
patterns. Some people prefer RSI, stochastics or MACD but any directional exposure you take by
legging in should be planned in advance and detailed in your plan.
ADJUSTMENT RULES

We will cover adjustments in detail shortly, but as a general rule, you want to be adjusting your
butterflies before the stock reaches your breakeven points on the payoff diagram. Some traders will
adjust their butterflies once the breakeven point is breached. I say a better method is to adjust
before the stock gets to that point. When looking at a butterfly payoff diagram, you can break the
profit tent into thirds. If the stock is in the middle third, you’re fine. Once it breaks into either of the
outer thirds, you should look to adjust. Looking at the diagram below, provided the stock stays
between roughly $272 and $278 there should be no need to adjust.

Looking at it another way, this is the same butterfly spread after 1 week. You can see how the profit
line is very flat between $272 and $277 but really starts accelerate downwards once you get past
those points. This is why adjusting based on the middle third makes sense and will help protect you
from large losses.
EXITS

Choosing (and sticking to) your exits points is where a lot of traders fall down. Getting into a trade is
the easy part, knowing when to get out is the hard part. With that said, let’s talk about some rules
for when to exit a butterfly trade. For simplicities sake we will look at a standard butterfly trade.

The easiest and most enjoyable exit is when your profit target is hit. For a standard butterfly, if
you’ve made somewhere in the range of 10-15% within about 10-15 days, then that is a very good
time to take profits. You can create a hard profit target if you prefer, such as exiting when you are
+15%. With options trading there are so many variables, so sometimes it is better to be a little bit
flexible with your rules. For example, if I’ve made 10% on a butterfly within 1 week, I would be quite
happy to exit at that point even if my aim was 15%. Never look a gift horse in the mouth because the
market can take profits away from you very quickly.

The other less enjoyable way to exit a butterfly is via a stop loss. Typically, the maximum loss that
you want to accept on a butterfly is around 20% but your acceptable level may be slightly higher or
lower than that depending on your risk tolerance and position size.

Another method for exiting a butterfly is slightly less common but still an important one and that is
using a timed expiry. As a butterfly approaches expiry, profits can fluctuate wildly if the stock is
within the profit tent. The last week of an options life is referred to as gamma week for this very
reason. Small movements in the underlying can have a big impact on your bottom line. For this
reason, you generally do not want to take a butterfly into expiry week. Some traders will be lured in
by the hopes of a significant return, but if you are treating your trading as a business, then you
should not accept huge fluctuations in your account from one week to the next. Slow and steady
wins the race.

In our next session, we’ll be looking at how to use butterflies to make cheap directional bets.

BUTTERFLY COURSE PART 5 – USING DIRECTIONAL BUTTERFLIES FOR LOW RISK HIGH REWARD
TRADES
Using butterflies to make cheap directional bets is one of my favorite strategies, so I’m going to
enjoy writing about this topic. So far we have only looked at the “traditional” way to trade
butterflies which is as a neutral income trade. You can use butterflies in many ways, so let’s delve in
to how you can use them to make low risk, high reward directional trades.

A traditional butterfly involves selling two at-the-money options. When using butterflies as a
directional trade, we place the sold options out-of-the-money. A trader with a bullish bias would sell
2 out-of-the-money calls and a trader with a bearish bias would use puts.

Before we go further into specifics, let’s first consider the reasons why you might trade an out-of-
the-money butterfly. The first reason is that it is a very cheap way to gain directional exposure, or
hedge an existing portfolio or position. Let’s say you are bearish on SPY over the next few weeks and
want to take a directional exposure. The most obvious way to do this would be to simply buy put
options. The main problem with being long puts is that you suffer from large amounts of time decay.
The stock needs to start moving down soon after you enter your trade otherwise the position starts
to decay.

SPY is trading at $161.20 on July 1st, 2013 and you think it might decline to $155 over the next two
weeks. You buy a July 19th $157 put for $0.89. Your risk is $89, your profit potential is unlimited and
your breakeven price is $156.11.

Date: July 1st 2013,

Current Price: $161.20

Trade Details: SPY Long OTM Put

Buy 1 SPY July 19th $157 put @ $0.89

Premium: $89 Net Debit

As you can see this position starts to make profits below $156.11, but you were only anticipating a
fall to $157. Assuming your directional view is correct and SPY drops to around $157 over the two
week period, a directional butterfly would be a much better choice both from a risk and reward
perspective. Let’s analyze the trade:

Date: July 1st 2013,

Current Price: $161.20

Trade Details: SPY Bearish Butterfly

Buy 1 SPY July 19th $153 put @ $0.39

Sell 2 SPY July 19th $157 put @ $0.89
Buy 1 SPY July 19th $161 put @ $2.06

Premium: $67 Net Debit

As you can see above, you are risking less capital, only $67 in this case, and looking at a nice return if
SPY ends around $157. We know achieving the maximum return on a butterfly is unlikely, but it’s
possible to make around a $200 gain if SPY close between $156 and $158.50. To make the same
$200 gain, the long put would have to decline to around $154.

Risking $67 as opposed to $89 may not seem like a big difference, but for someone trading 10
contracts the difference would be $2,200 less capital at risk. That’s pretty significant if you ask me.

Let’s look at some further examples of directional butterflies, this time using RUT. First, let’s analyze
a traditional neutral butterfly.

Date: July 1st 2013,

Current Price: $989

Trade Details: RUT Neutral Butterfly

Buy 5 RUT Aug 15th $970 call @ $36.45

Sell 10 RUT Aug 15th $990 call @ $23.90
Buy 5 RUT Aug 15th $1010 call @ $14.10

Premium: $1,375 Net Debit

Now let’s look at a RUT Bearish Butterfly:

Date: July 1st 2013,

Current Price: $989

Trade Details: RUT Bearish Butterfly

Buy 5 RUT Aug 15th $880 put @ $3.90

Sell 10 RUT Aug 15th $900 put @ $5.65
Buy 5 RUT Aug 15th $920 put @ $8.15

Premium: $375 Net Debit

Looking at the payoff graph above, you can see that this is a very attractive trade from a risk reward
standpoint. Risking $375 to (theoretically) make nearly $10,000 is a good deal to me. Of course, RUT
would have to drop around 10% for that to happen, but you can’t argue with the risk reward ratio.
This type of trade is great to put on at the end of a long bull run when you think the market is due
for a correction, or you can use it as a very low cost way to insure a portfolio of stocks.

There are a couple of other things to take note of here. The Vega on the bearish butterfly is positive,
whereas with a traditional butterfly it is negative. Also Theta is negative, so time decay is working
against you in this strategy. Hopefully it’s obvious, but you are not using this as an income trade
which is what butterflies are typically used for.

Lastly, let’s look at a directional butterfly using out-of-the-money calls for a bullish trade:

Date: July 1st 2013,

Current Price: $989

Trade Details: RUT Bullish Butterfly

Buy 5 RUT Aug 15th $1030 call @ $7.20

Sell 10 RUT Aug 15th $1050 call @ $3.05
Buy 5 RUT Aug 15th $1070 call @ $1.20

Premium: $1,150 Net Debit

Here again, you can see a pretty favorable risk reward ratio, but the trade is much more expensive
than the bearish butterfly, in fact it is not that much cheaper than the neutral butterfly. There are
two reasons for this, firstly put options are skewed due to the fact that markets tend to fall faster
than they rise. As such, out-of-the-money puts are more evenly priced compared to the calls. Once
you start to go deep out-of-the-money with the calls, those options have very little value. You can
see this in the option prices of the bullish and bearish butterflies. The put strikes were traded at
much more even prices – $8.15, $5.65 and $3.90. The calls were traded at a much greater variance –
$7.20, $3.05 and $1.20. The second reason is that the bullish butterfly is not as far out-of-the-money
as the bearish butterfly. The sold puts are $90 below the price and the calls are only $60 above. The
reason for this is I wanted to have a similar delta (i.e. similar probability) of the short strikes for both
the puts and calls. The delta of the short $900 puts was -0.12 and the short $1050 calls was 0.12.

A FEW THINGS TO KEEP IN MIND

Directional butterflies might be completely new to you, so let’s go over some things to keep in mind
before you dive in.

Butterflies are a net debit trade so we want to be paying as little as possible. You have to weigh up
the cost of the butterfly with how far you expect the stock to move. The further out-of-the-money
you go, the cheaper the trade will be, but the less likely that the stock will end near your sold
options. You can use delta as a guide such as I did here, you can look at support and resistance levels
or use a standard deviation measurement.

Short term trades are great with this strategy. I generally don’t advocate trading weekly options, but
in this case, directional butterflies using weekly options are a great way to get leverage on your
directional opinion. I find around 15 days is a good sweet spot, but you can still go further out in
time such as I did with RUT above.
Set a price target for the stock and structure your butterfly with the short strikes at that level. Try to
think about where the market has the potential to go. Could it move 5% in a week? 10% in a month?

You might find this strange to hear, but Theta and Vega are not overly important in this trading
strategy. The Neutral RUT butterfly has Vega of -73 and Theta of 44, but the directional trades were
18, -4 and 33, -11 so the exposure to these greeks is much less of a factor with directional
butterflies.

Given that you are risking such a small amount of capital, you can accept a greater loss than you
usually would for a traditional butterfly. For example with the RUT Bearish Butterfly only requiring
$375 of capital, I would be willing to accept up to a 50% loss on the position.

It can make sense to hold these position until closer to expiry than you normally would with a
traditional butterfly. The leverage is what we’re after here, so it makes sense to hold out for that big
winner given we only have a small amount of capital at stake.

Unlike other directional trades, a large move in the opposite direction early in this trade will not
have dire consequences. Compare that with a long put or long call which can be decimated by an
adverse directional move.

If your stock rises (or falls) too much, you can roll up (down) the credit spread and still stay in the
trade.

Using short term directional butterflies can be a great way to hedge a credit spread or iron condor
that is under pressure while allowing you to remain in the trade.

Trading a butterfly in this manner is a directional trade, you still need to stock to move in the
direction of your sold options in order to be profitable. The benefit of this type of trade is that the
cost of being wrong is minimal.

BUTTERFLY COURSE PART 6 – THE GREEKS

In today’s lesson, we’re going to be looking at the greeks of butterfly trades.

Understanding option greeks is vitally important with most option strategies and that is definitely
the case with butterflies. Greeks for a neutral long call butterfly, long put butterfly and iron butterfly
are all going to be very similar. I will discuss the greeks for a traditional neutral long call butterfly
spread and you will know that the same can apply to the other varieties of neutral butterflies.

DELTA

A typical butterfly spread is set up with the short strikes placed at-the-money. It doesn’t take a
genius to realize that the delta of a neutral butterfly will be zero (or very close to), but what happens
when the stock prices moves away from your short strikes?

If the stock falls, your butterfly becomes positive delta. If you think about it, this makes sense. When
the stock falls, your point of maximum profit is above the current stock price, therefore you want
the stock to rise. Positive delta indicates that you will make money as the stock rises.
The opposite can be said if the stock rises. Your point of maximum profit is now below the current
stock price, so you want the stock priced to fall. Therefore, you have negative delta.

This is shown graphically in the image below. The dotted line represents a shorter dated option and
the solid line represents a longer dated option. You can see that the effect is more pronounce in the
shorter dated option. In other words, the delta (directional) risk is greater in shorter term butterflies.

GAMMA

Gamma is a hugely important greek to understand when trading butterflies as I have previously
alluded to. Important and frequently overlooked. Gamma is the reason why the delta of a butterfly
changes from positive to negative. For those that are unfamiliar with gamma, a quick discussion
might be in order before we look specifically at butterfly gamma.

Gamma represents the rate of change of an option’s delta. An option with a gamma of +.05 will see
its delta increase by +.05 for every 1 point move in the underlying.

Delta neutral trades don’t stay neutral for long and the reason is gamma. To understand how
gamma works, let’s look at an example. Assume you buy a 30 day, 50 delta straddle and a 90 day, 50
delta straddle. Both positions have the exact same delta, so how will they perform if the stock
moves? The one with the highest gamma will do better, in this case the shorter dated trade.

Gamma is at its highest with at-the-money options. Looking at SPY call options with 16 days to
expiry, you can see the gamma is highest around $161 – $163. From this you can deduce that at-the-
money butterflies have a large (negative) gamma risk.
Gamma will be higher for shorter dated options as you can see below. Gamma for the July at-the-
money calls is around 0.08 whereas the September at-the-money calls are 0.03. For this reason, the
last week of an options life is referred to as “gamma week”. Most professional traders do not want
to be short gamma during the last week of an options life.

Net sellers of options will be short gamma and net buyers of options will be long gamma. This makes
sense because most sellers of options do not want the stock to move far, while buyers of options
benefit from large movements.

A larger gamma (positive or negative) leads to a larger change in delta when your stock moves.
When trading butterflies, it definitely pays to keep an eye on gamma. When the stock is outside the
wings of a butterfly, the trade has positive gamma. This indicates that the trade will gain delta as the
price rises and lose delta as the price falls.

When the stock is right at the middle strikes you have a large negative gamma exposure. A large
negative gamma means you don’t want the stock to move far. This makes sense for a butterfly when
you are right at the middle strikes.

As the stock moves up from the short strikes the butterfly will lose delta (and probably go from
neutral delta to short delta as we discussed above). As the stock falls from the short strikes the
butterfly will gain delta (going from neutral to positive delta).

The negative gamma exposure on a butterfly trade is a lot more than on other popular income
trades like iron condors.

VEGA

Neutral butterflies are short Vega. The Vega exposure is similar to the gamma in that you have a
large short Vega exposure at the short strikes and positive Vega outside the wings. So Vega works
against you around the short strikes, but then when the stock starts to move away, it actually begins
to work in your favor.
In the first few days of a butterfly, volatility will have the biggest impact on profits out of all the
greeks. For example a RUT 45 day at-the-money butterfly has a Delta of -2, a Gamma of 0, a Vega of
-31 and Theta of 4. Vega is by far the biggest exposure and will have the biggest impact.

Butterflies have a very similar payoff diagram to a calendar spread, the main difference being that
butterflies are negative Vega while calendars are positive Vega.

THETA

Theta is the exact opposite of gamma. You have a large positive Theta (you make money as time
passes) when the stock is right at the short strikes and you have negative delta (losing money as
time passes) when the stock is out beyond the wings.

That’s it for today, in the next lesson we’ll look at Broken Wing Butterflies which I call the “One Size
Fits All” Strategy.

BUTTERFLY COURSE PART 7 – BROKEN WING BUTTERFLIES – ONE-SIZE FITS ALL

Today we’re looking at the “one-size fits all” strategy that is broken wing butterflies.

Along with directional butterflies, broken wing butterflies are one of my favorite strategies. How
would you like a trade that provides income if a stock goes one way, and capital gains if it goes the
other way? That’s the potential you have with broken wing butterflies.

A broken wing butterfly is sometimes referred to as a “skip-strike” butterfly and you will understand
why once you see the trade setup. A regular butterfly has the bought options an equal distance from
the sold options, whereas a broken wing butterfly will skip a strike on one side of the trade. This
reduces the cost and in some cases will actually result in a net credit meaning you can use it as an
income trade.

The other way to think about broken wing butterflies is that they are simply an out-of-the-money
credit spread, protected by a slightly narrower, closer to the money debit spread. This is what the
payoff diagram looks like:

Note that there is a (albeit small) income portion to this trade if SPX stays below 1670 and the typical
butterfly profit zone located between 1670 and 1690. The drawback with this trade is the increased
risk on the upside, but keep in mind the index has to go through the profit zone before entering this
danger area. Ideally you want the index to slowly drift up into the profit zone and expire around
1680. However, you also don’t mind if the index drops in which case you would just let the entire
trade expire worthless and bank the income portion of the trade.

The above example is using SPX and assumes you are slightly bearish due to some overhead
resistance, but are concerned that momentum may carry the index slightly higher. The income
portion of the trade is $100 and the risk is $900 which is an 11.11% return. Not bad considering you
will make this return if the stock:
– Moves lower
– Stays flat
– Rises by less than 2.75%

Let’s not forget you also have the potential to make a large gain within the profit zone. The upper
breakeven point of the profit zone is around 4% higher than the current index price so you have a
reasonable margin for error. The best time to make these types of trades is at the end of a long bull
run, where the stock or index is almost exhausted, but could potentially muster another 2-3% rally. If
that happens, you are in the profit zone. If the stock reverts to the mean, you bank the income
portion.

Hopefully you can now see why I love this trade. Here is how the above SPX trade was set up:

Date: July 5th 2013,

Current Price: $1624

Trade Details:

Buy 1 SPX Aug 15th $1670 call @ $9.85

Sell 2 SPX Aug 15th $1680 calls @ $7.25
Buy 1 SPX Aug 15th $1700 call @ $3.65

Premium: $100 Net Credit

Let’s take a look at the same idea but using a standard butterfly. Instead of buying the 1700 call for
$3.65, this time we are buying the 1690 call for $5.30. The increased cost of the 1690 call results in a
net debit for the trade, albeit only a small one.

Date: July 5th 2013,

Current Price: $1624

Trade Details:

Buy 1 SPX Aug 15th $1670 call @ $9.85

Sell 2 SPX Aug 15th $1680 calls @ $7.25
Buy 1 SPX Aug 15th $1690 call @ $5.30

Premium: $65 Net Debit

You might be able to better visualize the different trade setups using this table below

With the directional butterfly you risk the prospect of full capital loss anywhere below 1670 or above
1690. With the broken wing butterfly, you profit anywhere below 1690, so the probability of success
is significantly higher.

The broken wing butterfly also turns the trade into more of a bearish trade as you will see from the
option greeks.

VARIATION – UNBALANCED BROKEN WING BUTTERFLIES

Aggressive traders can use the features of a broken wing butterfly and take them to the next level by
trading an unbalanced broken wing butterfly. The idea is that you have your regular broken wing
butterfly and then add extra short vertical spreads. You could also call this a ratio spread with out-of-
the-money protection.
This type of trade increases the income potential, but also increases the risk, which is why I
mentioned that it is more suitable for aggressive traders.

Using our SPX example, we can increase the income potential to $460, the trade-off being an
increase in capital at risk to $2540. Still that is an increase in the income portion of the trade from
11.11% to 20%. Here’s how you would set up the trade:

Date: July 5th 2013,

Current Price: $1624

Trade Details:

Buy 1 SPX Aug 15th $1670 call @ $9.85

Sell 3 SPX Aug 15th $1680 calls @ $7.25
Buy 2 SPX Aug 15th $1700 call @ $3.65

Premium: $460 Net Credit

The unbalanced broken wing butterfly becomes more of a directional trade than the other two as
you can see from the greeks below. You still get the nice profit zone on the upside if the stock
continues to rise, but this trade is much more bearish due to the negative delta.

With the unbalanced broken wing butterfly, all of the greeks are significantly higher than the other
two trades. Still it’s a great strategy but it might take some getting used to. You can read more about
this strategy online at the Futures Magazine.

BUTTERFLY COURSE PART 8 – THE REVERSE BUTTERFLY

Today we’re going to look at a Reverse Butterfly.

Reverse Butterflies are not an overly common trading strategy but they can have their place in
certain environments. Where you would normally enter a regular butterfly if you were expecting
little movement in the underlying stock, a Reverse Butterfly trader is expecting a large movement in
the stock.
The right time to enter a trade like this would be if a stock has been trading sideways for several
weeks and you are expecting a breakout but are unsure of the direction.

A Reverse Butterfly is constructed in the opposite way to a regular butterfly. Instead of selling two
at-the-money calls and buying the wings, you are buying the two at-the-money calls and selling the
wings.

Sell 1 in-the-money call

Buy 2 at-the-money calls
Sell 1 out-of-the-money call

As with a regular butterfly, the wings are placed an equal distance from the middle strike. Here is an
example of how a trade might look:

Date: July 30th 2013,

Current Price: $1691

Trade Details: SPX Reverse Butterfly

Sell 1 SPX Sept 19th $1660 call @ $51.80

Buy 2 SPX Sept 19th $1690 calls @ $31.80
Sell 1 SPX Sept 19th $1720 call @ $16.40

Premium: $460 Net Credit

Notice that this trade is entered for a net credit so we are receiving money when we place the trade
unlike a regular butterfly. This net credit is also our maximum gain for the trade. Here is how the
payoff diagram looks.
This diagram is the exact inverse of a regular butterfly. The profit potential on the trade is $460 and
the maximum loss is $2,540 for a potential return of +18.11%. Notice that the breakeven points are
at 1665 and 1715, so SPX only needs to move -1.85% or +1.16% for this trade to be profitable. Over a
7 week period, it is very likely that the stock will move further than that.

If the stock does not move as expected, you would want to exit this trade well before expiry to avoid
the maximum loss. On a 7 week trade such as this one, if the stock has not moved past the
breakeven points after 3 to 4 weeks you would want to exit.

A good profit target on this trade would be 10% but if the stock moves quickly outside the breakeven
points, you could hold until expiry for a full profit. Setting a stop loss of between 10-20% would also
be advisable.

When this trade was entered, the VIX was at 13.45 which was on the low end of the recent 6 month
range. It’s best to enter this trade when volatility is low and that is generally the case when the stock
has been moving sideways with small daily candles. When volatility is low, the bought options are
cheaper which allows you to achieve a better potential return on the trade.

Reverse Butterflies are long Vega which is another reason why this trade should be entered when
volatility is low and a rise in volatility is expected. Let’s take a look at the Greeks. You can see we are
more or less delta neutral for now, but we still want a big move in the stock. The trade is long Vega
as well, so a rise in volatility will be beneficial.

Reverse Butterflies are not a commonly used strategy, but they can have their place in a low
volatility environment.

Stayed tuned for the next installment where we will be looking at using butterflies as part of a
combination of strategies and also how to use them as a hedge for iron condors.

BUTTERFLY COURSE PART 9 – USING BUTTERFLIES IN A COMBINATION OR AS A HEDGE

Today we’re going to be looking at using Butterflies as part of a combination and using them to
hedge other income trades.

Using Butterflies as Part of a Combination Strategy

So far we have looked mostly at using butterflies as a stand-alone trade, as both neutral and
directional trades. Another skillful way to use butterflies is as part of a combination strategy or as a
hedge for other trades.

Iron Condors are a popular income trade and adding at-the-money butterflies can increase your
Theta decay, potentially allowing you to exit the trade earlier for the same amount of profit. Let’s
take a look at an example:

Date: July 31st 2013,

Current Price: $1052

Trade Details: Iron Condor

Long 10 RUT Aug 15th $980 puts @ $1.45

Short 10 RUT Aug 15th $1000 puts @ $2.45
Short 10 RUT Aug 15th $1090 calls @ $1.25
Long 10 RUT Aug 15th $1110 calls @ $0.35

Premium: $1,900 Net Credit

The payoff diagram is shown below. You can see we are risking $18,100 for a profit potential of
$1,900.

Now if we want to increase our Theta and Vega exposure we can add a couple of at-the-money
butterflies. A ratio of 2 butterflies for every 10 condor spreads is reasonable, but you can increase or
decrease this depending on your opinion on volatility.

Trade Details: Adding 2 at-the-money butterflies

Buy 2 RUT Aug 15th $1030 calls @ $28.30

Sell 4 RUT Aug 15th $1050 calls @ $14.30
Buy 2 RUT Aug 15th $1070 calls @ $5.10

Premium: $960 Net Debit

This gives us a profit diagram that looks like this. Notice that the capital at risk has increased by the
cost of the butterfly and that we now have a large profit tent in the middle of the graph. The profit
potential outside of the butterfly wings has dropped from $1,900 down to $940.

This type of trade would be perfect after a volatility spike where you are expecting the stock to trade
sideways for 1-2 weeks. Let’s compare the greeks of the iron condor and the combination position.
The key points here are that your Vega and Theta have both increased.

Using Butterflies As A Hedge

My preferred method for using butterflies as a hedge is when another income trade such as an iron
condor is moving against me and threatening my short strikes. If you have ever traded iron condors,
you will know that a stock aggressively moving towards your short strikes puts your position under
significant pressure. Sometimes you will be forced to take losses for fear that the stock might
continue trending, resulting in rapidly increasing losses.

When this occurs, some traders will take losses and close the trade and some will adjust and wait for
the market to move back the other way before expiry. Butterflies are a great way to hedge under
pressure iron condors as I will show you.
While keeping in mind there is no perfect hedge, incorporating a butterfly as a hedge for an under
pressure iron condor can achieve the following things:

– Reduce your delta exposure allowing you to contain losses

– Allow you to stay in the trade longer and delay taking losses
– Potentially achieve larger gains
– Ride the trend rather than fight it

Let’s look at an example of how this might play out. The following is a RUT iron condor on July 8th
where the short calls were under pressure. RUT had risen from a low of $942 on June 24th to $1009
on July 8th.

Date: July 8th 2013,

Current Price: $1008.93

Trade Details:

Long 5 RUT July 18th $940 puts

Short 5 RUT July 18th $960 puts
Short 5 RUT July 18th $1030 calls
Long 5 RUT July18th $1050 calls

At this point, the short calls were starting to get a little too close for comfort and the delta was
getting to a point where it needed to be adjusted. Rather than the traditional methods of rolling iron
condors which increase capital at risk, I could use a butterfly. Here’s how it could be done by adding
the following trade:

Trade Details: Butterfly Hedge For In Trouble Iron Condor

Buy 2 RUT July 18th $1010 calls @ $10.30

Sell 4 RUT July 18th $1030 calls @ $2.65
Buy 2 RUT July 18th $1050 calls @ $0.45

Doing this changes the profit graph to look like the following. Notice that there is now a significant
profit zone centered around the short call strike of $1030.

Making this adjustment has increased capital at risk by about $1000, but that isn’t too bad
considering the alternatives. Keep in mind that potential profits on the upside has also increased.
The income portion of the trade has dropped from $1500 to $750 but that’s ok as this hedge is more
concerned with defending the short strike of 1030. The delta exposure has been cut in half, so losses
from any further upside in RUT will be lower than if the condor was left as it was.

If in a couple of days, RUT declines, you can then remove the butterfly at a small loss and then you
have your existing condor back.
You can do the same move in the puts if the market is attacking your short puts.

Unfortunately in this case, RUT continued to move higher and the position had to be closed for a
loss. However, the butterfly hedge helped to keep losses lower than the would have been from just
holding the condor.

BUTTERFLY COURSE PART 10 – HOW TO PROTECT AGAINST FAST MOVES

Today we’re looking at how to protect your butterfly trades against fast moves in the stock.

How often does it happen where you put on a trade and then within hours, sometime even minutes,
the stock goes on an absolute tear and leaves you sitting on large losses? It happens all the time and
it’s really annoying!

With butterflies, there is a way to give you a little bit of protection against this.

Let’s say you put on a standard neutral butterfly but are concerned that the market might rocket
higher. Adding an extra call can give you a great deal of protection against this without adding much
more risk on the downside.

Let’s look at an example:

Date: August 5th 2013,

Current Price: $170.70

Trade Details: SPY Neutral Butterfly

Buy 5 SPY Sept 20th $165 calls @ $6.80

Sell 10 SPY Sept 20th $170 calls @ $3.05
Buy 5 SPY Sept 20th $175 calls @ $0.80

Premium: $745 Net Debit

Now we’ll add the extra call.

Trade Details: SPY Neutral Butterfly

Buy 1 SPY Sept 20th $175 calls @ $0.80

Premium: $825 Total Net Debit

Looking at the payoff diagram at expiry you might not immediately see the benefit of this variation
as the stock would have to move a long way to the upside in order to reach a profit. However, the
main benefit comes if the stock makes a fast move early on in the trade.
Let’s assume that SPY continues to rocket higher and climbs 5% in the next three weeks to around
$180. At this level, the standard butterfly would be showing losses of $650 which is nearly a
complete wipe out.

The extra call variation will be showing losses of around $220 which is significantly lower than the
standard butterfly, and all it cost you was an extra $80.
BUTTERFLY COURSE PART 11 – THE BEARISH BUTTERFLY

The Bearish Butterfly is an advanced rules based strategy developed by a friend of mine called John
Locke (no, not the guy off Lost). I won’t go into too much detail here, but the basic premise is that
you enter a butterfly below the current stock price and then use reference points to add to, or adjust
the trade. You start with one-third of your total position size and then add the rest if the market
rallies.

Keep in mind the bearish butterfly trade outlined here is a high risk, high reward trade so it’s not for
everyone.

The trade is always entered with 56 days until expiry. RUT is the favored instrument and the initial
butterfly is centered 20 points below the current RUT price. Your reference point is the centre of the
butterfly and the adjustment points are then calculated as follows:

Reference point +40 – add second 1/3

Reference point +60 – add last 1/3
Reference point + 70 – roll lowest butterfly +60
Reference point + 80 – roll lowest butterfly +60
Reference point + 90 – roll lowest butterfly +60

So assuming at initiation of the trade RUT is at 1050, you enter a butterfly with 1/3 of your position
size, centred at 1030. If RUT then rises to 1070 (i.e. 40 points above your butterfly centre), you add
the second butterfly centred at 1050. If RUT then breaks 1090, add the last butterfly at 1070.

If RUT continues to rally and breaks above 1100, close the 1030 butterfly and move it to 1090.

In terms of risk management rules and profit target the guidelines are set out as such:

Start with 20 contracts (10 butterflies) for the short strikes and scale to 60 contracts if fully scaled
into. Of course you can reduce these numbers if you have a smaller account size.
Wing Span – Anything from 20 to 50 is ok. The wider the spread, the more expensive the trade, but
the larger the profit zone

Planned Capital – $50,000

Minimum Capital Suggested in Account – $100,000

Profit Target – $15,000

Reduced Profit Target – $5,000… 21 DTE or closer

Max Loss – $15,000

Some people like the rules based approach of the bearish butterfly, but it’s not for everyone. The
strategy relies on the fact that at some point the market will provide a pullback into the developing
profit zone that you are creating with the bearish butterfly. Markets that grind higher without much
of a pullback such as we have seen a few times in 2013 can be a disaster for this trade. When this
trade loses, it can lose big.

BUTTERFLY COURSE PART 12 – ADJUSTMENTS!

The ability to adjust trades is what sets great traders apart from average traders. Some traders may
prefer not to adjust and just stick to the standard profit target and stop loss. Adjusting can allow you
to turn a losing trade into a profitable trade, but it does involve risk and can make your trade more
complicated. More traders blow up their accounts through bad adjustments than through bad trade
initiation, so keep that in mind.

When it comes to adjusting butterfly spreads, there are plenty of ways to go about it and I will
introduce some of the more common methods.

For a neutral butterfly, some traders like to adjust once the breakeven point on the profit graph has
been exceeded. As mentioned previously, if you want to be a little more cautious, you can adjust
when the price moves into the outer third of the profit tent. The other method is to adjust the trade
when losses hit 6-7%. Either method is fine, but keep in mind that when you adjust from a losing
position, you will either decrease your profit potential or increase your risk.

For any trading strategy, it is a good idea to have at least 6 months of experience in a variety of
market environments before allocating a significant amount of capital to the strategy.

One method of adjusting a butterfly is to add a second butterfly once the breakeven point on the
profit graph is reached. The advantage of this is that it gives you a new profit zone near where the
stock is currently trading and gives you a nice wide profit zone for the stock to land in. The
disadvantage is that you are allocating more capital to the trade. Generally it is not a good idea to
continue throwing more capital at a losing trade.

Here’s how it works.

On August 12th, 2013 with RUT trading around 1050, you enter a September 1030-1050-1070 call
butterfly spread. Four days later RUT is trading at 1030 and you need to adjust.
Date: August 12th 2013

Current Price: $1050

Trade Details: RUT Call Butterfly Spread

Buy 5 RUT Sept 19th $1030 call @ $36.40

Sell 10 RUT Sept 19th $1050 calls @ $23.35

Buy 5 RUT Sept 19th $1070 call @ $12.95

Premium: $1,325 Net Debit

On August 16th, with RUT trading at 1030, we add a second butterfly centered at 1030

Date: August 16th 2013

Current Price: $1030

Trade Details: Second RUT Call Butterfly Spread

Buy 5 RUT Sept 19th $1010 call @ $31.95

Sell 10 RUT Sept 19th $1030 calls @ $19.40

Buy 5 RUT Sept 19th $1050 call @ $10.15

Premium: $1,650 Net Debit

By making the adjustment we have added another $1,650 in risk capital to the trade, and in effect
created a profit diagram that looks like a mini iron condor. The new position looks like this:

Long 5 RUT Sept 19th 1010 calls

Short 5 RUT Sept 19th 1030 calls

Short 5 RUT Sept 19th 1050 calls

Long 5 RUT Sept 19th 1070 calls

Total Capital at Risk: $2,975

Maximum Profit: $7,025

With RUT at 1030, you don’t have a lot of room to move on the downside with the breakeven point
being around 1015. Theoretically, if RUT continues down you can add a third butterfly, but this is
again going to increase capital at risk and decrease potential profits.

Here are the Greeks before and after the adjustment:

Another adjustment you might choose to make is adding call credit spreads. You can do this in a
couple of ways. Using the example above, with RUT at 1030 we could sell some additional 1050-
1070 credit spreads to turn the trade into something that looks like a Broken Wing Butterfly. You
could call it that, or you could call it a Credit Spread With Protection. Either way, this is how you do
it.

Date: August 16th 2013

Current Price: $1030

Trade Details: Adding Call Credit Spreads

Sell 5 RUT Sept 19th $1050 calls @ $10.15

Buy 5 RUT Sept 19th $1070 call @ $4.60

Premium: $2,775 Net Credit

We are bringing a large credit in for this trade, meaning the total net credit received is now $1,450.
The disadvantage is that we have significantly increased our capital at risk when compared with the
previous adjustment of adding another butterfly. We now have $8,400 at risk in the trade as
opposed to $2,975 in the previous example.

The other potential pitfall with this adjustment strategy is that you now have a significantly short
delta. That may be ok if your market opinion has changed and you think the market is entering a
new downtrend. But you may not want to take such a strong directional exposure. Here is how the
greeks compare:

As you can see, you now have a very short Delta at -65. Delta is also higher than Theta whereas
before the adjustment it was one third of Theta. The iron condor adjustment gave you a delta
neutral position.

If you like the look of the Broken Wing Butterfly adjustment, but are concerned about the delta
exposure, there is a way to cut delta without adding any extra risk capital to the trade. We do that
by adding some put credit spreads. Here’s how:

Date: August 16th 2013

Current Price: $1030

Trade Details: Adding Put Credit Spreads to Reduce Delta

Sell 5 RUT Sept 19th $980 puts @ $7.70

Buy 5 RUT Sept 19th $960 puts @ $4.90

Premium: $1,400 Net Credit

Your profit diagram at expiry now looks like this:

This extra piece of the adjustment has the added benefit of bringing in more income, while not tying
up any extra margin or capital. We have now received a total net credit of $2,850 and our delta has
been cut to -30.

With this last adjustment you should keep in mind that you now have a pretty complex position that
is going to be difficult to adjust if the trade gets into further trouble. You want to weigh whether it is
worth making this adjustment, or if it’s better to just take your losses and close the trade. The other
disadvantage of this adjustment is the number of trades you are making is increasing, so you are
incurring more commission costs and more slippage through the bid/ask spreads.

Adjusting Profitable Trades – The Reverse Harvey

The Reverse Harvey is an adjustment strategy developed by Mark Sebastian and Dan Harvey. The
idea behind the adjustment is that you want to lock in profits on a winning trade. With successful
butterfly trades, once time passes, the sensitivity to movements in price increases. In other words,
the slope of the current risk graph becomes more pronounced.

If the stock makes a large move, your profits can quickly disintegrate. Due to higher levels of short
gamma the closer you get to expiry, your P&L will fluctuate more wildly.

You can see this in the 2 diagrams below. With the stock right at the short strike, a move of 30 points
would result in a decrease in profit of roughly $1,500 for a trade with 40 days to expiry and $8,500
for a trade with 10 days to expiry, quite a significant difference!

Profitable Butterfly With 40 Days To Expiry

Profitable Butterfly With 10 Days To Expiry

The increase slope is caused by increased gamma as you approach expiry and the fact that the wings
provide less protection. If the stock is right at the short strikes and there is not much time to expiry,
the time premium of the outer wings will have almost evaporated and no longer provide much of a
hedge. For this reason it makes sense to “tighten the noose” in order to protect profits as time
passes. This is where the Reverse Harvey comes in.

The Reverse Harvey involves selling the outer wings and bringing them in closer to the short strikes.
This provides more of a hedge for the short at-the-money options and reduces the overall short
gamma of the trade. As a result the profit graph becomes more smoothed out again.

To watch the video by Mark Sebastian on the Reverse Harvey, visit this link. The example given in the
video by Mark is this:

Date: Jan 4th 2011,

Current Price: $1274

Trade Details: SPX Iron Butterfly

Buy 10 SPX Jan 21st $1235 puts

Sell 10 SPX Jan 21st $1270 puts

Sell 10 SPX Jan 21st $1270 calls

Buy 10 SPX Jan 21st $1305 calls

After 3 days the trade is showing a decent profit, so Mark brings the wings in 10 points.

Date: Jan 7th 2011,

Current Price: $1275

Trade Details: Reverse Harvey Adjustment

Sell to close 10 SPX Jan 21st $1235 puts

Buy to open 10 SPX Jan 21st $1245 puts

Sell to close 10 SPX Jan 21st $1305 calls

Buy to open 10 SPX Jan 21st $1295 calls

This is the adjusted risk graph. The pink line is the adjusted position and the red line is the original
position. You can see that the risk graph as of today (dotted line) is much smoother after the
adjustment and the other added benefit is the capital at risk is greatly reduced. Mark suggests
performing a Reverse Harvey adjustment once you are up about 5% on an Index butterfly.
BUTTERFLY COURSE PART 13 – TRADING WEEKLY DOUBLE BUTTERFLIES

Weekly options have become increasingly popular in recent years. In this chapter, we’ll be looking at
how to trade double butterflies using weekly options.

Using double butterflies to trade weekly options can work really well if you like the idea of a “set and
forget” strategy. With short-term butterflies you can enter trades relatively cheaply, particularly if
you move further out-of-the-money. By using a double butterfly, you don’t care which way the
underlying moves, as you are creating profit zones to the upside and downside.

To set up the trade, you place a call butterfly spread above the current market price and a put
butterfly spread below the current market price. A good guide is to have your short strikes centered
just outside a 1 standard deviation move in the underlying instrument. I like to initiate the trade
anywhere between 7 and 10 days to expiry.

Generally this will be fairly cheap to set up. The reason I called this a “set and forget” strategy, is that
once you put on the trade, you leave it until expiry (note you should only do this with European style
Index options). This helps reduce commission costs and slippage as there is no exit for the trade. As
the trade is cheap to set up, you are willing to accept a 100% loss on the trade.

Here’s an example of how you set up this trade:

Date: August 6th 2013,

Current Price: $1698

Trade Details: SPX Weekly Double Butterfly

Buy 1 SPX Aug 15th $1625 put @ $0.80

Sell 2 SPX Aug 15th $1650 puts @ $1.80

Buy 1 SPX Aug 15th $1675 put @ $4.80

Premium: $200 Net Debit

Buy 1 SPX Aug 15th $1725 call @ $1.60

Sell 2 SPX Aug 15th $1750 calls @ $0.35

Buy 1 SPX Aug 15th $1775 call @ $0.10

Premium: $100 Net Debit

Total Premium: $300 Net Debit

At the time of trade entry, a 1 standard deviation move would have put SPX at 1665 or 1731 at
expiry.

Here’s how the profit diagram looks. Note that the trade is risking very little capital and there are
two very nice profit zones to the upside and downside. You will profit anywhere between -4.10% to -
1.50% and +1.80% to +4.30%. If you got lucky and SPX settled at 1650 or 1750, you would collect a
nice profit of $2,200.

SPX ended up settling at 1657 for the August 15th expiry. The call butterfly expired worthless
resulting in a loss of $100 while the put butterfly made a profit of $1600 thanks to the long 1675 put
and short 1650 puts. Overall the trade made $1500 in profit for a return of 500%.

This won’t happen every week of course, but this is a nice profit for a low stress, inexpensive trade.
You only need to a have a winning trade every few weeks to make it worthwhile.

You can also increase your chances of success by waiting for 1-2 quiet weeks of less than 1%
movement before initiating the trade. This gives you a greater chance that the index will move the
required 1 standard deviation.

I just finished reading all the chapters of this well-compiled course, thanks so much for sharing this
with us. I appreciate all the time you have put in to setup this course. Butterflies are my favorites,
and go-to strategy and I will share this with my friends who are willing to learn about this.

Couple more variations that I use personally and did not see covered here is, I have different
understanding or usage for how unbalanced butterflies are.
Just like how you move one strike out for the broken wing butterfly, I will move that leg one strike
backwards. This way, if the stock moves fast, breaches through all the legs, I actually turn a profit
(because my debit spread > credit spread in width). This is what I call unbalanced. Extra premium
but less risk.

The second variation I have is what I call the 1-3-2 butterfly.

Buy 10 SPX 2700 Call
Sell 30 SPX 2750 Call
Buy 20 SPX 2775 Call
In this, I reduce the total debit paid to open the trade by selling 3 calls but I reduce the width of
credit spread (25 points wide) to half the width of my debit spread (50 points wide). This way, you
don't take in additional losses, and this holds well when you are not expecting the underlying to
make a large move.

The market plummets easily so may be don't trade BWB on the put side, you can surely take a shot
on the call side with a BWB. Mix and match!

LONG STRANGLE OPTION STRATEGY

Expecting a big move from a stock but not sure of the direction? Then the long strangle option
strategy is the trade for you.

This explosive options strategy can generate big profits in a short period of time, but, like any option
strategy that involves owning long options, time is against you.

The big move needs to happen sooner rather than later, otherwise you will find your position slowly
eroding each day from the dreaded time decay.

The long strangle also has a huge exposure to implied volatility. All else being equal, the trade will
make money if implied volatility increases after opening the trade and lose money if implied
volatility decreases.

Even if the stock doesn’t move, a spike in implied volatility due to an unforeseen event, might allow
the trader to close out the position early for a profit.

3-Part Long Strangle Video Series

Set Up

A long strangle is constructed by buying an out-of-the-money put and an out-of-the-money call with
the same expiration date. Traders might prefer the long strangle over the long straddle due to the
reduced cost. However, they will need a bigger move from the stock in order for the trade to be
profitable at expiry. How far out-of-the-money to place the call and put would depend on the
trader’s outlook for the stock and how much money they are willing to risk. Typically traders will
place the calls and puts an equal distance away from the stock price. For example, it a stock was
trading at $50, a trader might buy a $45 put and buy a $55 call.

PICKING A PRICE TARGET

If a trader was expecting a 10% move in the stock, they would want to place the strangle within
that range. A strangle that has the two legs 10% away from the current price, will require a move of
greater than 10% (at expiry) in order to profit due to the cost of the trade. However, this trade could
still be profitable before expiry if there is a big move. This can be seen in the image below.
This trade was set up on June 15th, 2015 on RUT. The blue line represents the profit or loss at expiry
and the purple line represents the profit or loss one week from trade initiation. You can see that a
sizable profit is achievable one week after opening if the index moves about 5%. To make the same
profit at expiry, the index needs to move over 7.5%.

Get Your Free Long Strangle Calculator

The strikes for this trade were just an arbitrary 50 points above and below the index price. Notice
that because of the volatility skew, the 1210 put is significantly more expensive than the 1310 call.

USING DELTA

Another way to select the option strikes is to use delta as a guide. Delta can be used as a rough
estimate of the probability of the stock reaching that strike at expiry. For example, a strangle trade
that uses strikes with deltas around 0.30 and -0.30 has a roughly 30% chance of expiring in-the-
money.

In the example above the deltas were 0.30 and -0.33. To make the trade completely delta neutral,
you could swap the 1210 put for a -0.30 delta 1200 put. That way, the trade would start
perfectly delta neutral, although it won’t stay that way for long. As the underlying index moves, the
net delta on the trade will move to either positive or negative depending on which way the index
moved.

Max Loss

The maximum loss on this trade is limited which is great, but a trader would not want to experience
a 100% loss on this trade given the large amount of capital required.

Straddles and strangles are expensive and need to be managed carefully to avoid significant loss.
Dan Nathan from Risk Reversal provides a good example of using a short straddle to offset the cost
of a long strangle. This article is well worth a read if you are concerned about the cost of a long
strangle trade.

The maximum loss will occur if the stock finishes between the put and call strikes at expiry. In this
case both the put and call will expire worthless and the trader would experience a total loss.

Long Strangle Vs Long Straddle

With a long strangle, the options are placed out-of-the-money, whereas a long straddle uses at-the-
money calls and puts. The straddle trade acquired its name due to the fact that the calls and puts
“straddle” the one strike.

The strangle trade places the calls and puts on either side of the stock price and “strangles” the
underlying stock or index. You can see the difference in the trade setup in the two images below.

You can see that the straddle is more expensive because you are trading the at-the-money options
which have the highest time premium component. The long strangle is a cheaper trade to place, but
requires a larger move before reaching the breakeven point. In this example, the straddle costs $800
and has breakeven points at $42 and $58 while the strangle costs $400 and has breakeven points at
$41 and $59.
Entry Points

The long strangle is a trade which requires a large move in the underlying stock in order to be
profitable. As such, one good entry criteria could be to wait until the stock has had a long period of
sideways consolidation before entering the trade.

Generally, stocks tend to revert to their long term average movement, so after a quiet period, the
stock could be ready to make a big move. Various chart patterns and techniques can be used to help
guide you in when to enter these trades. Triangles, Channels, Wedges, Flags and Pennants are all
relevant chart patterns that could be used for an entry criteria.

These patterns all exhibit similar characteristics in that the stock is either range bound or coiling in a
tighter and tighter range, just before it breaks out. If you feel like a stock is ready to breakout, but
are not sure of the direction, a long strangle is a great trade.

Here are some examples:

SYMMETRICAL TRIANGLE AND BREAKOUT

CHANNEL AND BREAKOUT
WEDGE PATTERN AND BREAKOUT
FLAGS, PENNANTS AND BREAKOUTS
More About Entries

Another important part of trade entry with a long strangle is to take a look at the current and
expected level of implied volatility which we will discuss in more detail shortly. As straddles and
strangles are long volatility trades you want to enter them when volatility is low and expected to
rise.

One of my favorite entries for a long strangle trade is when you see a Bollinger Band squeeze. This
works especially well when the Bollinger Band Width is near the lowest point seen in the last 6
months and when the stock price is near the middle of the very narrow Bollinger Bands. In the EWZ
chart below, you can see two very favorable entries based on these criteria.

The first signal saw a move from $34.50 down to below $29 in 9 trading days. That’s a 16% move,
and the fact that it occurred on the downside would have given a long strangle an even bigger boost
due to the implied volatility expansion. Around that time, implied volatility moved from 31% to 38%
which really helped the long strangle trade. Remember long strangles are positive vega and
therefore benefit from a rise in implied volatility after the trade is placed.

The second signal occurred in mid-May and saw an 11% move from $36 to $32 in 10 trading days.
Again, this occurred with an accompanying rise in implied volatility which gave the trade an extra
boost. During this period, implied volatility rose from 26% to 32.5%.

These types of setups and moves only tend to occur a few times per year, but when you do catch
them, the results can be outstanding.
I placed a long strangle trade on EWZ in my own account, although I was a few weeks early on the
entry. You can see below that even though I entered the trade on February 4th, I still made a handy
profit. This profit would have been much larger if I had entered the trade towards the end of March.

Exits

It’s great when a trade goes to plan and you can take a profit. Generally, for a long strangle trade, I
am happy with a 20-25% return on capital at risk and will tend to take profits at that stage or slowly
scale out of the position.

On the downside, I tend to stick to a 20% stop loss.

Long strangles are a very theta intensive strategy and as time passes, the amount of time decay you
suffer will increase exponentially. For this reason, it makes sense to close out long strangles once
1/3 of the time to expiry has passed. If neither my profit target nor stop loss have been hit, but this
much time has passed, I typically close the trade to avoid the losses from time decay that are
accumulating.

The Greeks

It goes without saying that the long strangle is a long volatility play. You’re looking for a big move in
either direction, or a jump in implied volatility. The battle is between capturing that move, against
the effects of time decay as each day passes.

The actual greeks will vary depending on how the trader sets up the trade, but typically most traders
start off delta neutral or close to it. Vega will always be positive and theta will always be negative.
Let’s work through some scenarios together. The following three RUT long strangle trades were set
up on June 15th, 2015.

The following three trades were placed when RUT was trading around 1260. The first trade was 3
months in duration and the strikes were placed 50 points out of the money. Here’s how the greeks
look.

Trade 1 – Sept 1210 – 1310 Long Strangle

Here’s what the greeks look like if we use the same strikes but go out to January 2016.

Notice that delta is pretty similar and more or less neutral, no major change there. Theta has come
down a bit. As we have gone further out in time, the impact of time decay on the trade is not as
great. Vega has had a significant impact jumping from 451 to 729. So, by going out further in time,
we have slightly reduced the time decay, but we have taken on a much greater exposure to changes
in implied volatility.

What happens if implied volatility drops after we enter these trades instead of rising like we
anticipated? The longer term trade (January expiry) would perform much worse as the impact of
changes in implied volatility is greater.

Trade 2 – Jan 1210 – 1310 Long Strangle

This time, instead of going further out in time, we move the strikes out further while staying in
September to make the trade a bit cheaper?

The first thing you should notice is that the implied volatility skew has become much more
pronounced. The puts that are 100 points out of the money cost $17.15 as opposed to 100 point
out-of-the-money calls at $5.05. As such the delta on the trade has become much more skewed to
the downside. We now have -9 delta as opposed to -3 on Trade 1 and +1 on Trade 2.

Trade 3 – Sept 1160 – 1360 Long Strangle

Going further out from the index price has made the trade cheaper ($2,200 as opposed to $4,470),
and our Vega exposure has dropped by about 30%, as has our theta. That’s all well and good, but
with this trade, we would need the index to move further to be profitable at expiry.

In the short-term though (1-2 weeks), there isn’t a huge amount of difference. So, if you can really
nail your timing, the further out-of-the-money strikes could potentially be more profitable on a
percentage basis. But, you would have to be pretty spot on with your timing.

Here is the RUT and Russell Volatility Index as of June 15th, 2016 for reference.
10 Weeks Later

On August 24th, stocks experience a precipitous drop, with RUT falling to near 1100. This is a pretty
big move from 1260 which is where RUT was trading when we initiated the trades. The majority of
the decline occurred in mid-August, so you can see that things can develop quickly which is ideal for
a long strangle.
Also notice that implied volatility skyrocketed, another massive bonus for a long strangle. Over the
course of just a few days, RVX jumped from 17.50 to 47!! How do you think our long strangles
performed in this scenario? Let’s take a look.
Trade 1 – Standard trade +$5,125 or 114%

Trade 2 – Further out in time +$2,525 or 26%

Trade 3 – Further out in price +$3,955 or 178%

You can see above that the two shorter-term trades (Sept) were the best performers in both dollar
and percentage profit, both returning well over 100% on capital invested. This is interesting given
that the January trade had the higher starting Vega.

Also note that after the decline, all three positions have a large negative delta. This is because the
calls have very little value left and are very far out-of-the-money. Most of the value in the long
strangle is in the puts. If the market bounced from here, the profits on the trades would quickly start
to reverse. Definitely time to take profits!

The Impact of Implied Volatility

Implied volatility is a very important component of a long strangle. In the first example we looked
at, vega was by far the dominant greek. If you refer back, you can see delta was -3, gamma was 1,
theta was 41 and in comparison, vega was a whopp1ng 451! Therefore traders need to be aware,
that changes in implied volatility will have a big impact on this trading strategy.

After entering the trade, if implied volatility rises, that will be very good for the trade, and the owner
of the long strangle might be able to receive a higher premium when they sell to close the trade.

Volatility cuts both ways though, and if a fall in implied volatility occurs after the trade is opened, the
value of the long strangle could fall significantly.

Implied Volatility and Earnings Announcements

An article on Schwab.com suggests opening a long strangle a few weeks prior to an earnings release.
Many times you will see implied volatility at low levels a few weeks out from a stock’s earning’s
report. Volatility then starts to rise as anticipation and uncertainty about the earnings report comes
closer. You can see this very clearly in the chart of Google’s implied volatility below. There is a clear
rise in implied volatility leading up to earnings releases in October, January and April. Following the
earnings release, implied volatility drops dramatically, so the trader would want to close the long
strangle before the announcement. Unless of course they are expecting a really big move in the
stock.

The volatility drop following an earnings announcement is very common, you can see a good
example with NFLX here.

Summary

The long strangle option strategy is a powerful strategy that can result in significant gains, but also
has high risks. Some things to keep in mind include:

 Long strangles have are a strategy that can produce large profits but also have the potential
for big losses
 You don’t need to predict which way the stock will move, only that it will make a big move
shortly after you enter the trade

 It is possible to make a profit from increases in implied volatility, even if the stock price does
not change

 The initial cost of the trade is high compared to other option strategies, but is still lower than
the long straddle

 The passage of time is not good for this trade. Traders need to stock to move (or implied
volatility to rise) before too much time decay kicks in

 Just as increases in implied volatility help the trade, decreases in implied volatility will hurt
the trade