Matt Baker |
Welcome to part 2 of a brand new series on one of my favourite strategies, the Butterfly. In this week’s article, I will be introducing the topic of ‘strike widths’. What does this mean? Well one of the major factors we consider in actually constructing the Butterfly is the width of the strikes we use. This week we are going to use an example with Apple Computers (AAPL). Please let me assure you, these are not trade recommendations, we are solely using AAPL as an example.
At the time of writing, Apple Computers is trading at $172.93. To construct the At-The-Money standard Butterfly with the narrowest strike width possible, we would be constructing the fly with $5 strike widths as follows:
Chart 1
click to enlarge
Chart 2
click to enlarge
As we can see in the Risk Graph, this trade will only cost us $57, and has a max profit of $442. Seems like a great reward to risk ratio, but what is the trade off? Look at the mouth of the fly. Look at how narrow it is, relative to how much AAPL moves around. As well, the $442 max profit only happens at one place and at one point in time – on expiration day, if AAPL was to close right on $175. What’s the probability of that happening? Probably about as much as winning lotto!
This doesn’t mean we discount Butterflies as a low-probability strategy. There are ways we can make them high-probability trades, and one way is by widening the strikes. Let’s widen the exterior legs a strike each, so we will raise the 180 call up to 185, and we will lower the 170 call down to 165. Let’s look at this new risk graph below:
Chart 3
click to enlarge
Chart 4
click to enlarge
We can immediately see the difference here. We have a wider mouth, which means more room to make profit. Is there a trade-off for having a fly with a wider mouth? Yes, we now have to pay more for the Butterfly: $220 instead of $57, but we have a wider area to make a profit, although not as much profit. For the final example, I will widen the legs a further 2 strikes out each way, so there is $20 between each strike. This fly would be called a ‘20 point fly’.
Chart 5
click to enlarge
Chart 6
click to enlarge
Naturally we can see in this risk graph we have a very wide mouth to make profit in, should AAPL move sideways from here, and of course we paid for it too. This is a classic example of a trade off between risk, reward and probability. This last trade has more risk, less reward but greater probability. Which trade out of the 3 is best? Neither – it depends on how much risk you want to take on primarily, how much reward potential you’d like, and how much probability you’d like of making some money.
Manage your trades!
Matt Baker
|