Butterfly Spreads
Sept. 2, 2007 Updated on Oct. 31, 2007
How do you reduce the cost of high priced options?
The high cost of buying an outright call or put option on many markets (i.e. S&P, Energies, Metals, and Grains) make ownership quite expensive and in most cases a bad bet unless held for a short period of time. The vertical spread is my first choice in placing a bet on which direction the market will go. That is a great strategy to use. But when you feel the market can move significantly in one direction, the vertical spread becomes expensive too, in order to capture a larger profit on a bigger move.
The next strategy I would look at is the butterfly spread (the Fly). Keep this in mind, all option strategies are custom tailored based on time, your thoughts, and ideas. The Fly spread really lowers the cost of buying an outright option when you need more than 3 months until expiration. The ultimate goal of this spread is to forecast where the market will be at expiration and if correct the reward is great, partly right and reward is very good, and barely right you still get even money. If wrong, you know exactly what your risk is and the exact amount you will lose. The other asset of this spread is that in any major move against your position, you still have time for the market to do what you thought, not become emotional, and not be stopped or forced out of your trade before you decide if the your market projections are still valid.
The simplest way to look at this spread is to understand that it is two vertical spreads. One spread you buy and one spread you sell. Options have infinite wagers; this is one of them for example:
The January 08 RBOB (RBF8) settled at 19275 on Friday 8/31/07.
The January options expire on 12/26/08. 1 tick is $4.20. 100 ticks is $420.
The January 195 call settled at 1198, (1198 X $4.20= $5031.60)
206 call settled at 821,
and the 217 call settled at 556.
Buy 1 RBF8 195 call 1198
Sell 1 “ 206 call -821
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377 ...This is what the 195/206 vertical call spread settled.
Sell 1 “ 206 call 821
Buy 1 “ 217 call -556
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265...This is what the 206/217 vertical call spread settled.
377-265= 112 or $470.40. This is what the cost would be buying the 195/206/217 butterfly spread if purchased on the close 8/31/07 and you were filled at settlement prices. This is how to be long the RBF8 195 call at 112 vs. the out right at 1198. There is trade offs though, and using this strategy with which strike prices to use is based on your thoughts.
This strategy is reflective of the opinion that on expiration, the RBF8 will be trading at 206. If correct, you paid 112 plus commissions and it is worth 1100 at 206. Almost a 10 to 1 risk reward. If RBF8 in fact settles only at 200, it would be worth 500 ticks, about 4 to 1 after paying commissions.
Compare that to buying an outright call. A 195 call costs 1198 ($5031.60) and would be purchased because you thought that it could rally very strongly and could go to 250 for example. If it did indeed go to 250, your profit would be...
250.00
-195.00
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55.00 is the value. You paid 1198..... 5500-1198= 4320 Profit. Not even 4 to 1 risk/reward and it had to go to 250 (22% more than 206) to get that! You need a close at 20698 to be even.
This high cost of premium is why the vertical spread might be better than buying the outright call, if you plan on keeping the trade until expiration.
If you just bought the 195/206 vertical call spread for 377, you could almost get 2 to1 odds (risk 377 to make 723 minus commissions) and the market just needs to be 206 to make the 2 to1 , not 206 at expiration to be even or 23094 to get 2 to1 on the outright call.
Now comes the butterfly spread.
Instead of buying the outright 195 call for 1198, or the 195/206 spread for 377, I can buy the “Fly” spread for 112 plus commissions. At 19612 you get your 112 back, and if wrong and the market goes down, you lose 112, instead of 377 or 1198.
The way to place this order on the phone is to say, “I want to buy the RBOB Jan8 195,206,217 butterfly spread at 112”. When you want to get out (or sell this spread) say, “I want to sell the RBOB Jan8 195,206,217 butterfly spread at 112 or whatever price. If you do this order electronically, check with your brokerage firm on how to do so.
Of course this strategy like all option strategies is based on your thoughts and time frame.
You could buy the 195/206 spread and if the market rallies (whenever) you could sell the 206/217 and turn your vertical spread into the butterfly. You can always take one option strategy and as the market and your thoughts change, you can morph into another strategy. Like playing chess, thinking and planning your next moves and possibilities, and executing based on your opponents or the markets next move.
If you thought the market will be 220 instead of 206, I would do the 200,220,240 fly spread (settled 256) and would profit 1744 ticks at 220.
When the market rallies, this spread goes up in value, and when the market goes down, it losses money. You can get out at any time as a spread or any option in the spread.
I make these comparisons to get you to think about options in a way that has not been explained to you before and hopefully in a way that will spark your interest.
In conclusion, if you think you can pinpoint the market, or believe you can be close, you can greatly reduce your risk and greatly improve your reward if right using the Fly. This strategy rewards you nicely if only partially right.
Updated Oct. 31, 2007
The simplest way to look at this spread is to understand that it is two vertical spreads. One spread you buy and one spread you sell.
The January 08 RBOB (RBF8) settled at 2.2666 on Tuesday 10/30/07.
The January options expire on 12/26/08. 1 tick is $4.20. 100 ticks is $420.
The January 195 call settled at 3265, (3265 X $4.20= $13,713)
206 call settled at 2350,
and the 217 call settled at 1583.
Buy 1 RBF8 195 call 3265
Sell 1 “ 206 call -2350
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915 ...This is what the 195/206 vertical call spread settled.
Sell 1 “ 206 call 2350
Buy 1 “ 217 call -1583
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767...This is what the 206/217 vertical call spread settled.
915-767= 148 or $621.60. This is what the cost would be buying the 195/206/217 butterfly spread if purchased on the close 8/30/07 and you were filled at settlement prices.
The 195 call outright gained about 160% on the cost of buying the outright (quite expensive at $5, 031.60 now $13,713)
The 195-206 spread went from 377 ticks to 915 (gain of about 150%)
The 206-217 spread went from 265 ticks to 767 (gain of almost 200%)
In the short term, this fly will go up in an up market and go down in a down market, until we get closer to expiration, then the closer it trades to the 2.06 strike the higher the more it is worth.
I would add to this position if I was neutral to bearish the next few weeks. I will update and you should continue to watch this spread on a daily closing basis to see how this spread reacts to the daily price movement of the underlying January futures contract.
