Matt Baker |
Welcome to part 3 of a brand new series on one of my favourite strategies, the Butterfly. In last week’s article, we will be dissecting the Butterfly in greater detail, looking at what makes up its components. In last weeks article we had a few examples of a butterfly on AAPL, (Apple Computers). We will be using the 3rd example today, which was the October 09 155 | 175 | 195 Call Butterfly, constructed on September 8th, 2009.
Chart 1
click to enlarge
Chart 2
click to enlarge
Let’s take a close look at chart 1. As a package, we call this a Butterfly, but what is it really? Simply said, we own an option at the 155 strike, we are short 2 options (have sold 2) at the 175 strike, and own another at the 195 strike. Simply 4 x single option transactions (although we don’t get filled on the trade that way. I'm just breaking the trade down into individual components).
Would there be another way to view these trade legs? How about if I presented the legs in this form:
| Buy |
1 |
195 |
| Sell |
1 |
175 |
| Sell |
1 |
175 |
| Buy |
1 |
155 |
This is actually what we have, but can you see 2 Call spreads in there? We have a 155 | 175 Call spread, and a 175 | 195 Call spread too. What types of spreads are they? In the lower one, the 155 | 175, we have bought the 155 Call and sold the 175 Call, bought lower and sold higher, so this is a Long Call Spread, or Bull Call Spread – a debit spread. In the higher one, the 175 | 195, we have sold the 175 Call, and bought the 195 Call, sold lower and bought higher, so this is a Short Call Spread, or Bear Call Spread – a credit spread.
That’s right, the Butterfly is nothing more than a Long Call Spread and Short Call Spread whose central legs share the same strike, and hence we end up Short 2 contracts of the same strike in the centre.
To confirm this let’s check the pricing. We’ll look again at chart 1 of the debit spread and check it’s a debit. For the lower spread we bought the 155 Call for $19.85, and sold the 175 Call for $6.48. Without doing the maths you can see already this is a debit spread, because we’re paying out more money than we’re bringing in. For the higher spread we sold the 175 Call for $6.48 and bought the 195 call for $1.17. Without doing the maths you can see already this is a credit spread, because we’re bringing in more money than we’re paying out.
In the practicality of trading, and especially when coming close to expiration, it really helps your trade management decisions in trading the Butterfly to view the trade as 2 separate spreads. More about that in an upcoming article!
Manage your trades!
Matt Baker
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