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Welcome to part 5 of a new article series on one of my favourite strategies, the Butterfly. In this week’s article, we will be looking at the Greeks of a Butterfly. We will use the example we have been using all along, a standard Call Butterfly on AAPL (Apple Computers). Let’s revise how the Greeks change: The Greeks change with stock price movement, movements in IV, and time passing by (time decay).
The butterfly is usually known as a sideways strategy, meaning a strategy where you can make money if the stock or index is trading sideways. Given that we supposedly make money from the Butterfly when the stock goes sideways, this implies that we are making money from time decay, and if we’re making money from time decay we would assume our Theta (time decay in a dollar amount) to be a positive figure. (When Theta is negative, we are ‘losing’ this amount of money in the next trading day!)
So let me ask you: Is Theta always positive in a Butterfly? Look at the chart below.
Chart 1
click to enlarge
Chart 2
click to enlarge
In this trade, we have a Theta of $7.79, meaning in the next trading day, all else being equal we’re going to make $7.79. Is Theta always positive throughout the trade? The answer is no – it depends.
If AAPL stayed right where it is in the risk graph, yes Theta would always stay positive, and would increase each day. But, Theta is only positive in the mouth of the Butterfly. Look at the vertical axis at the stock price levels of 150 and 210 as an example. At these parts Theta is ‘negative’. This means if the stock is at these levels, outside the mouth, you will be losing money from time decay each day.
Specifically, the point where Theta changes from being positive to negative is at the point of inflection of all the coloured lines – the 2 points at which they cross. Outside of these points (higher on the upside and lower on the downside) is where Theta becomes negative. But why do we have to know this? It helps with trade management.
It can often be easy to miss seeing the Greeks change. It’s easy to think when trading a Butterfly that it’s going to make money as time goes on, but now you know – only when Theta is positive.
Let’s take an example of AAPL going down in price, out of the mouth of the fly, past the inflection point to about $150. Theta will be negative here. Think about this. When ‘sideways’ trades make money, the only way they do is by time decay (and sometimes IV crush), but if Theta actually goes negative, the question is “how do we make money now?”
The Greeks would have changed here. Look at the risk graph again, and now look at the shape and slope of the red line, at the $150. Block out the mouth of the Butterfly and the upper part – just look at the red line at this point. It looks like a Long Call option risk graph doesn’t it! And what Greeks would be different in a Long Call? Lots of positive Delta and a little negative Theta. That is what we would have here at the $150 level.
Now, the only reason you would have a trade on with lots of positive Delta is if you were bullish on the stock. Ask yourself, “am I bullish on AAPL now”? Don’t just answer yes because you’re already in the trade. Pretend you didn’t have the trade on – would you answer yes?
If you answered no, then ask yourself, “well why am I staying in this trade?” Remember, the only way for the trade to make some money is if the stock went up (positive Delta and NO positive Theta). So if you don’t believe it’s going up, this is a point where you may decide to close the trade.
Manage your trades!
Matt Baker
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