The Butterfly. Option Pit

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Victor Quinn
7 years ago
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1 The Butterfly Option Pit

2 Today We will talk about the butterfly How to Execute the Spread How to decide what fly to use Secrets to its success A couple of Adjustments

3 What is an Butterfly A fly is a combination of a call or put credit and debit spread on successive strikes Creates a ratio of 1 by 2 by 1 where the trade is typically short the middle options In the case of an Iron fly the trade is short a straddle and long a surounding strangle Also may be considered selling an ATM call spread and selling an ATM put spread at the same time. The net creates a tightly defined, high yield area for the spread to profit from

4 The Butterfly

5 Additionally An butterfly is in many ways simply a straddle that is hedged Traders like having defined risk in this trade instead of the unlimited risk of a straddle Can also be used as a cheaper directional options vs. a call or put spread (we will not address this approach today) Can be used as a long gamma play (again we aren't covering this today)

6 Characteristics The long OTM put will typically have a higher delta than the long OTM call The spread wants the underlying to stay in a tight range and not to move The spread is selling premium thus it is looking to collect time decay

7 Essentially The fly is a race: can the spread collect premium before the underlying starts to take off The more time passes, the more the spread makes, the more tempting it is to go for premium

8 Chart

9 Call/Put/Iron In theory a call fly, put fly and iron fly are all the same trade Put and Call flies should be the same price Cost of carry can screw this up due to a DIV, but that is unusual Take the Strike width to the center, less the cost of the put fly or call fly should give the trader the price of the iron fly

10 Calculating Take the time to compare all three versions of the spread If one spread is.05 cheap that is the spread that should be executed If one can do a.05 better in and out of the spread, one can make a serious impact on the performance of a portfolio

11 Keys to Success An butterfly will perform well when IV is normal or below normal and falling Not a good sale in elevated IV generally Be fine with selling into falling IV Try to catch the VIX falling from 25 to 20, do not try to sell this spread when the VIX is at 35 Can perform great in a stable IV environment as well

12 Keys to Success A trader wants HV to be falling as well as IV One result of high IV is really high HV Part of the reason that we don t sell high IV is because HV is so high We are looking for the stock to STOP moving or slow down There are a few other key things we cover in the gold course, this is just an overview

13 Good

14 Bad

15 Time We want to use the acceleration of time decay to our advantage. Unlike the IC inside of 30 days is key Because its an ATM fly, we can really do these whenever we want, the key is to be able to manage the gamma Can even be an expiration play There is NO time limit on these trades but think shorter term

16 Credit Try and get a favorable risk/reward based on the risk in the trade (use the platform) If the trade has about an 30% chance of success, try to make 70% return on risk or better More credit is better

17 Strikes Use 1 standard deviation based on the number of days you intend to be in the trade. For 30 days out For a weekly, try and set the exit at wed. of expiration Always a good place to set the time limit Use the IV x (calendar days to close/365) sq rt. Or use (trading days to close/252) sq rt.

18 flatten the delta Delta Buy the calls to flatten INSIDE the tent Do not buy a lot of calls outside the tent Fewer contracts more deltas is better The less short delta the better

19 Shoot for 10-15% MGMT Do not lose more than 10% Never lose more than 20% Absolute max loss Do not touch unless down by 5% or outside of tent Use smart adjusting Don t throw capital at a fly

20 Tighten Up The Reverse Harvey can be used to clean up a butterfly and keep the trader in the trade Adding an IC to pull in the wings Hitting a target profit doesn t mean the trader needs to be out of the trade Lets walk a butterfly now

21 Summary A call fly=a put fly=a short iron fly Look for flat or falling IV A butterfly is a race against time Don t just sell for fun, take time to sell best spread

22 Special: Take our One Day Saturday Class for off, just 113 for a 4+ hour class USE CODE:Fly25 mark@optionpit.com andrew@optionpit.com 1(888) Trade-01

FINANCIAL ENGINEERING CLUB TRADING 201

FINANCIAL ENGINEERING CLUB TRADING 201 STOCK PRICING It s all about volatility Volatility is the measure of how much a stock moves The implied volatility (IV) of a stock represents a 1 standard deviation