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Welcome to Part 15 of my series of articles on the Butterfly. In this week’s article we are going to look at another Butterfly case study taken from LiveTrade. There are many live case studies presented each week for students to look at, study and even follow along. Each trade is presented by one of our top Optionetics instructors. The particular one below was presented by Mr. Jeff Beamer.
Chart 1 and 2 show the Platinum risk graph for a Call Butterfly on HES. Taking what we know now from previous articles, let’s study the construction of this Fly in a little more detail. The prognosis simply is that the stock will travel slightly higher over the next month or so, to around the $65 level. Looking at Chart 2, you can see the clever placement of the mouth of the Butterfly – just a little higher than the stock at the time of inception. At inception the stock was trading at $61.80. The view was that the stock would travel up to around the $65 mark, so the mouth of the Fly was placed right here, at $65.
How do we actually construct the fly, with the mouth (and maximum profit area) at a particular area? The answer is: This is where we place our Short strikes (the sold options), or the ‘body’ of the Fly. Looking at the leg details in chart 1, you can see we are Long 1x 60 Call, Short 2x 65 Calls and Long 1x 70 Call. The mouth of the Fly is always going to be where the Short strikes are, at $65 in this case.
Chart 1
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Chart 2
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We understand now why the Short strikes are at $65, but let’s see where the other two legs were placed. The two long options of the Butterfly are at $60 and $70, surrounding the ‘body’. The stock at inception was trading at $61.80; meaning one of our legs here seems to be In The Money!
The $60 Call is actually ITM, by $1.80. This may spark some alarm bells for some people in regards to exercise and assignment, but for the most part there is nothing to worry about, especially in a 51 day trade. There may be some assignment risk very close to expiration, and if a particular leg was deep ITM. Until then, whether a leg is In, At or Out of the Money makes no difference at all. (We are not going to be in the trade in the couple of days leading up to expiration anyway so that situation should not arise).
To construct a trade like this, our first step must be looking ‘visually’ at the chart, and asking the question “Where do I want to place this fly, based on the prognosis I have?”. Constructing the initial placement involves deciding where to place the Short strikes as we have discussed, and also how wide to make the body (how far apart to place the Long strikes).
There is more that goes into the initial construction, such as looking at the Greeks too, but we can go into this in another article.
Chart 3
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Chart 4
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Chart 3 and 4 show the Butterfly at the time of writing (April 8th, 2010). The Butterfly is doing exactly as we planned and is already showing a small profit. There are many other great trading case studies in LiveTrade. There is a free trial period too which I encourage all students to explore! www.optionetics.com.au/livetrade7days
Manage your trades!
Matt Baker
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