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Welcome to part 1 of a brand new series on one of my favourite strategies, the Butterfly. Last weekend we held the 2009 Expert Strategies seminar in Sydney which I attended. The speakers Tom Gentile and Nick Gazzolo spent a large portion of the seminar on Butterflies. We all began to see why Butterflies are so popular!
Butterflies are so adjustable. There are so many ways you can construct them, place them and trade them. I'm going to go through some different Butterflies in this series of articles and reveal some of the beauty of these creatures.
Firstly let’s just briefly go over how a Butterfly is constructed. The Butterfly comprises 4 legs, but at 3 strike prices. To construct the Fly you would buy one lower call, sell two calls at a higher strike and then buy one more even higher for protection. The same would apply for using puts. Commonly, this is how the construction may look.
| Strike |
Contracts |
| 50 |
+ 1 |
| 45 |
- 2 |
| 40 |
+ 1 |
Our first example of a Butterfly is an Out-Of-The-Money Butterfly. This means that all the strikes of the Fly are OTM. One of the great things we can do with OTM Butterflies is place them extremely far OTM, and a long way out in time. You could do this if you had a long term bullish view on a stock or index. Let’s have a look at a long term OTM Butterfly on USO (United States Oil Fund)
Chart 1
click to enlarge
Chart 2
click to enlarge
As we can see from the Risk Graph, USO doesn’t have to move up too much to be in the mouth area of the butterfly, and the best thing is that we have 156 days in the trade, until expiration January 2010. In addition to this the trade only costs $105, so should USO go down or never make it, we only lose $105, per contract.
There is much more potentially to analyse, such as the Greeks, the movement and behaviour of the coloured time lines, and even how we scanned for this trade. We will go into some of these details in upcoming parts in the series. For now let’s simply learn that this is a way we can take a long term view on a stock or index, with a very low risk, a high reward potential and a wide profit area.
Manage your trades!
Matt Baker
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