Last week I hosted an on-line Signature Series presentation titled “Finding Unique Opportunties with the Out-of-the-Money Butterfly Finder.” Just kind of rolls of the tongue, doesn’t it? Okay, let’s be honest… it is a bit of a mouthful. It is also one of those topics that will cause the vast majority of individuals to say, “huh,” and move on to something else. And I understand that completely. However, that is not necessarily a good thing. As I have been trying to emphasize in recent weeks, it is my opinion that people will likely need to do something other than just put money into mutual funds and wait for the market to go up if they wish to prosper in the years ahead. So as a result, it is also time to consider other possibilities. Hence the reason for presentations with titles like “Finding Unique Opportunties with the Out-of-the-Money Butterfly Finder.”
A butterfly spread is basically a “neutral” strategy. In other words, if you expected or aniticapted that a given security was going to trade in a particular range, you could enter a butterfly spread by buying one in-the-money option, selling two at-the-money options and buying an out-of the-money option. By doing so, you stand to make a profit if the underlying security remains within a particular price range.
One such possibility is depicted in Charts 1 and 2 using option on IWM, which is an exchange-traded fund [ETF] that emulates the Russell 2000 small-cap index. This trade involves buying one December 35 call, selling two December 45 calls and buying one December 55 call. This trade has a maximum risk of $535 and will show a profit at option expiration if IWM (presently trading at 46.10) is between 40.38 and 49.62.
Chart 1 - At-the-money butterfly spread using IWM options
click here for larger view 
Chart 2 - Classic “neutral” strategy
This is an example of a “neutral” trade – one designed to take advantage of a choppy market, high implied option volatility and time decay. It’s your “classic” going nowhere option trade. And of course, if your luck is anything like mine, anytime you expect something to “go nowhere,” it almost immediately “goes somewhere.” Which, again, is precisly the kind of thing that leads to such out of the way topics as “Finding Unique Opportunities with the OTM Butterfly Finder.”
Looking for Direction
The OTM Butterfly Finder routine in Optionetics Platinum Software is the brainchild of John Broussard and Ray Vos. And what this routine allows you to do is to essentially move the range of profitability associated with a butterfly spread trade to higher or lower ground. Let’s look at a couple of examples.
To the Upside
Let's assume you think that the worst is over for now for the stock market and that the Russell 2000 index may drift higher in the next several weeks. One possibility for taking advantage of this scenario is depicted in Charts 3 and 4. This trade involves buying one December 44 call, selling two December 52 calls and buying one December 60 call. The maximum risk on this trade is $258. With IWM at 46.10, this trade will show a profit at expiration in 14 days if IWM is at any price between 46.58 and 57.42.
Chart 3 - Butterfly Spread with some upside potential
If IWM breaks down prior to expiration and appears unlikely to rise back into the profit range, it is possible to close the trade early and to cut one’s loss significantly, depending on how far IWM has fallen and how much time has passed.
Chart 4 - Expecting IWM to drift higher prior to December expiration
To the Downside
Now let’s consider the flip side. The stock market sold off massively and has since staged something of a bounce. An individual might be concerned that the market will drift back lower in the weeks ahead and possibly retest the recent lows again. Based on this outlook a trader might consider the same type of out-of-the-money butterfly, only this time using put options instead of call options. In essence, the trade will be a hedge against a declining stock market. At least to a point.
In Charts 5 and 6 you see a trade that involves buying one December 48 put option, selling two December 40 puts and buying one December 32 put. This trade has a total dollar risk of $247 and will show a profit at option expiration if IWM is at any price between 34.47 and 45.53.
Chart 5 - Butterfly with some downside profit potential
Chart 6 - Expecting IWM to drift lower prior to December expiration
Summary
These are simple examples. And by the time you read about these it may be too late to act on these particular ideas. But that is okay, because these are not intended to be “recommendations.” These examples are simply intended to make the point that there are many ways to make money in the markets if you are willing to devote a little time and effort to learn. Even the OTM Butterfly has a few “fine points” associated with it. For example, near-term OTM butterflies have negative vega; thus high implied volatility is better. Conversely, far out-of-the-money butterflies have positive vega; thus low implied volatility is better. You know, stuff like that.
With the stock market beaten down and with many huge question markets hanging over the economy going forward, it would seem like a good time for investors to learn some new ways to take money of out of the market beyond simply waiting for the stock market to go up. Now let’s be honest, most individuals will likely never “find the time” to master the butterfly spread, let alone the out-of-the-money version of the same strategy.
Still, based on the simple examples presented here and the world of unique opportunity that trades like these offer, well, more’s the pity.
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Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
