Sunday, March 11, 2012

butterfly stroke

at the li swimmers meeting this saturday i initiated a discussion about a strategy that is called broken-wing butterfly. so i just wanted to rehash that here briefly.

first of all it is necessary to understand what a butterfly is, so here's the basic recipe: buy an option at strike 1, sell two of the same kind of options at the next higher strike, and, lastly, buy an option of the same kind at the next strike above the options sold.

here's how the standard butterfly looks on the equity we were referencing, gmcr:
standard butterfly on gmcr

you can see that this is a low risk/high reward kind of trade but with low probability. one should expect to see these go out with a small loss most of the time. at the peak of the sweet spot centered on 60, there is the potential for profit of $228 and the more likely loss limited to only $17.

now to break a wing, we replace the most out-of-the money option purchased with the next further out-of-the money option. in the example above that would mean buying the APR12 65 CALL instead of the APR12 62.5 CALL. here's how this transforms the trade:

broken-wing butterfly on gmcr

breaking the wing transforms this trade from low probability to high probability. at the peak of the sweet spot this bwb will produce $268 of profit and the flat area below 57 is a $22 profit. the trade off is that there is now a higher risk to the trade with max loss of $228 occuring for prices above $65.

these bwb's only tend to price for a credit like this when implied volatility has spiked. in this case news was released that starbucks was coming out with a single-serve coffee maker and this caused gmcr to gap down.  that you can trade these bwb's reactively like this is what appeals to me. the strikes were chosen to place the sweet spot at the top of the gap, the theory being that that this is where gmcr is likely to find resistance. furthermore implied volatility is likely to decline as gmcr rises into the sweet spot which helps develop profit in this trade. for this reason, i am not sure it is wise to trade the opposite, a broken-wing put-fly, in reaction to a gap up. it is likely that they would not have the IV spike to be initiated with a credit and the tendancy of IV to increase with declining prices would work against it.

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