Q&A
Explore Your Options
| Got a question about options? Tom Gentile
is the chief options strategist at Optionetics (www.optionetics.com), an
education and publishing firm dedicated to teaching investors how to minimize
their risk while maximizing profits using options. To submit a question,
post it on the STOCKS & COMMODITIES website Message-Boards.
Answers will be posted there, and selected questions will appear in future
issues of S&C. |
Tom Gentile of Optionetics
|
BUTTERFLY SPREADS
Would you be so kind to explain what exactly a butterfly spread
is? Thanks - Simon
A butterfly spread is a sideways market strategy using all calls or
puts, and is designed to profit from a stock trading in a specific range.
They are often cheap to place, offer high rewards, and can be profitable
within a few days to a few weeks; so they are ideal for shorter-term swing
traders. The construction of the spread generally involves selling (shorting)
two contracts in the middle of a stock range (the body) and buying two
contracts (the wings) on either side of the short position, one with a
higher strike than the short contracts and one with a lower strike. (See
Figure 1 for a risk curve.) Your maximum profit on the trade is the difference
between the short and long strikes, minus the net debit. Your maximum risk
is the total debit minus the credit received for the shorts. The breakevens
are calculated by adding the net debit to the lowest strike to get the
lower breakeven and subtracting it from the highest strike for the upper
breakeven.
FIGURE 1: RISK CURVE FOR BUTTERFLY SPREAD
Identifying support and resistance levels is one of the key components
in setting up a traditional butterfly spread. Using basic technical analysis,
you should be able to easily identify the support and resistance levels
of the stock or underlying and place your long positions at each end of
the range. It is not a hard-and-fast rule that the body be shorted in the
middle of the range, but it is a good start when analyzing your risk/reward.
Let's look at an example:
Suppose that on February 5, stock XYZ has been trading in a three-month
range between 40 and 50. The stock currently sits at 45. Since you feel
that the stock will continue to trade within this range over the next few
weeks, you would like to make some money while it meanders back and forth.
Let's construct a trade using the following strikes and prices:
February 40 put = 0.50
February 45 put = 2.50
February 50 put = 6.00
In this example, the total debit of the long positions is 6.50 and the
credit received is 5. Therefore, the risk on the trade is the net difference
between the two, or 1.50 ($150 per spread). Your maximum profit is 3.50,
or $350 per spread. As long as the stock trades between 41.50 and 48.50,
you're profitable; your maximum profit is right at 45. It's as simple as
that.
Generally, these spreads are very low-risk when done correctly and offer
very high rewards. If the implied volatilities of the options happen to
be a little higher when placing this trade, it could be an even greater
benefit to you. As the volatility comes down, you could profit faster as
the time premium in the short contracts dissipates.
SUPERIOR LEVERAGE
Since most of the books out there say that simply buying calls
and puts is a losing strategy for most who try it, are there spreads that
offer superior leverage or risk management in intraday time frames? Thanks
- Craig
Unless you are a market maker, retail traders are very limited in their
ability to profit from intraday spread trading due to slippage (the difference
between the cost and what you end up paying) and commissions. That's not
to say it can't be done; however, in most cases, since profiting on, say,
a bull or bear spread requires at least a few points of movement in the
underlying, it's generally not a good idea to daytrade these types of strategies.
These days, stocks just don't have the same wide range of movement that
we saw a couple of years ago, when it may have been more appropriate to
trade in this manner.
That said, it's important to know that depending on your risk tolerance,
you can still daytrade some options with relative safety without the use
of spreads. And although it's not something I typically promote for most
traders, there are some cases where trading profits can be made quite frequently
using very short-term time frames. During periods of low volatility, for
example, many of the indexes, such as the Standard & Poor's 100 and
500 indexes, offer some of the highest liquidity and cheapest prices (relatively
speaking) in the options market - particularly in the days prior to expiration,
when there is very little time premium left.
As with any type of strategy, it is only as good as the risk management
of the trader using it. This is why many people lose at investing, whether
they are daytraders or long-term buy-and-holders. If you have a method
in mind to implement, be sure to test it on paper for a while to get a
sense of how well it really works. Be honest with your tests and yourself;
you should only begin to put real money into any strategy after you have
seen positive results for a series of similar trades with identical setups.
If you're trading options for the first time, it's important to know that
it's usually when novice traders don't take the time to truly understand
the implications of volatility and time decay that they lose. Remember,
options don't lose money, people do!
Originally published in the April 2003 issue of Technical
Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2003, Technical Analysis, Inc.
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