Saturday, February 2, 2013

butterfly morph's

it's been a tremendous bull run this january. however, with the experience of trading in the past few years, i now fear a backlash. i am just not used to a trending market. to address these fears, i have been experimenting with a different way of finishing-off winning short option trades: the butterfly-morph.

a butterfly is simply two verticals, a credit-spread and a debit-spread, that share a common short-option strike. because the credit offsets part of the debit, they can be very inexpensive and sport a large reward IF the underlying expires in the vicinity of the short option strikes. that's a big 'IF' because the target vicinity is usually a narrow price range. low risk/high reward = low win/high loss, there's no free lunch ... or is there?

here's the risk profile of a typical butterfly trade:

february spy 'fly
16.48% of the time there will be some gain in this trade but 83.52% of time there will be a full loss (ignoring the miniscule transition ranges.) this is a win/loss ratio of .197 so a $20($8 + $12 in round-trip commissions) investment means i would have to make $101 (=20/.197), at least as a possibility, to break-even on a steady diet of butterflys. since our maximum return on this trade is $92 it would seem this is not a business-quality strategy. this is not even your typical casino-quality trade, since the maximum return only occurs for the exceedingly rare event of the underlying pinning the short option strike at expiration. these butterflys are lottery tickets. why would any investor want that!?

i would want that because i can get the lottery tickets essentially for free. suppose i am in a cash-covered, short-put trade. say, short the spy feb 149 put, that i sold for $2 a while back. today i can buy back this option for 59 cents and i could roll this position to march but there is a decent amount of time left in february. for a few cents more than the cost of buying back the feb option i can purchase a 'morph' - i buy the feb 150 and 148 puts and sell one more feb 149 put, all for 65 cents. this metamorphizes my trade into a butterfly,  but, this is a butterfly that was legged-in for a net credit of $1.29 ($2-.65-.06commissions). by doing so, i lock-in $1.29 of profit and retain a free lottery ticket that could help ease the pain of a retracement.

but it gets better. once i have purchased the morph, the buying power allocated to the original cash-covered put, enough to buy 100 shares of spy at the price of $149 each, is returned to my account because there is no further risk of loss in the trade. with the released buying-power i can initiate a new cash-covered put position in march and continue onward prepared for most of whatever.

now, the lunch isn't really free. i gave up 6 cents and commissions of unrealized profit. however, this is lunch money that could easily be lost in the slop while waiting for a more opportune time to roll and it buys a disproportinate amount of peace-of-mind.

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