Butterfly Options » Stock Options

What Is Options Trading?

admin — Sun, 24 Jan 2010 11:41:07 +0000

An option contract is an agreement between two parties to buy/sell an asset (In this case, the asset refers to stock) at a certain price and specific date.
It is called an option because the buyer is not obliged to carry out the transaction. If, over the life of the contract, the asset value decreases, the buyer can simply elect not to exercise his/her right to buy/sell the asset.
There are two types of option contracts – Call options and Put options. A Call option gives the buyer the right to buy the underlying asset, while a Put option gives the buyer the right to sell the underlying asset.
A simple example: Peter buys a Call option contract from Sarah. The contract states that Peter will buy 100 Microsoft shares from Sarah on the 5th May for $25. The current share price for Microsoft is $30.
Note: this is an example of a Call option as it gives Peter the right to buy the underlying asset.
If the share price of Microsoft is trading above $25 on the 5th May, then Peter will exercise the option and Sarah will have to sell him Microsoft shares for $25. With Microsoft trading anywhere above $25 Peter can make an instant profit by taking the shares from Sarah at the agreed price of $25 and then selling the shares on the open market for whatever the current share price is and making a profit.
The $25 value, which is stated in the agreement, is referred to as the Exercise (or Strike) Price. This is the price at which the asset will be exchanged.
The date (in this case 5th May) is known as the Expiry (or Maturity) Date. This date is the deadline for the option contract. At this date, the option buyer is to decide if a transaction of the underlying asset is to occur.
Outcomes: Let’s imagine that at the expiration date, Microsoft is trading at $30, then Peter will buy the shares from Sarah at the agreed $25 and then he can sell them back on the open market for $30 and make an instant $5.
Alternatively, if Microsoft is trading at $20, then buying the shares from Sarah at $25 is too expensive as he can buy them on the open market for $20 and save $5. In this situation, Peter would choose not to exercise his right to buy the shares and let the options contract expire worthless. His only loss would be the amount that he paid to Sarah when he bought the contract, which is called the Option Premium – more on that a little later. Sarah would, however, keep the option premium received from Peter as her profit.
All in all, there are more than 50 strategies you can deploy in options trading by combining many different strike prices and expiration. But do you need to know all?
The good news is you do not have to!In fact, most of them allow you to make money very slowly or limited.

Naked Option Writing â the Cadillac of All Option Trading Strategies

admin — Mon, 18 Jan 2010 11:43:39 +0000

Letâs be clear on this. There is no other option trading strategy that can outshine or even equal the profit generating potential of the sport of writing naked options. The term âsportâ is used here because those who practice this money making trading technique not only turn out fabulous profits but also have fun in the process. It is a fun, profitable but dangerous option trading sport that is mostly played by seasoned and skilled option players. That is, until the sportâs perilâs were tamed with the use of trading techniques that, while offering substantial safeguards to the player, still continued to offer high profitability ratios, albeit at slightly reduced rates. Having made it âinvestor safeâ has only slightly altered the profit potential of writing nakeds and certainly, without doubt, continues to be the premiere money making trading strategy in the options market.

The birth of the options market in recent decades spawned the creation of dozens of trading strategies and systems that is today being used not only by individual options traders but also by financial institutions. Stock options as an investment instrument is now widely employed as a safe and sound money strategy. The ability of options to give the investor a wide range of choices in stock market investment is what has made the options market grow by leaps and bounds over the last two or three decades. There are dozens of option trading systems being employed by individual investors as well as financial institutions. Each system is designed to accomplish a specific investment goal. A financial institution may use long put options to hedge its winnings in stocks that have appreciated in value, another investor may buy call options instead of stocks to enter a position in a security that has caught his fancy. Still another may sell calls against his stock holdings to generate income from his stock position, or what is now popularly known as covered call writing.

Trading strategies, techniques and systems available to the option trader are so numerous today that it would take a whole book to describe each and that would be just a brief description not a detailed explanation. It would be far beyond the scope of what we could cover in this short article. Most of the strategies are based on the principle of buying calls and puts or, variations of this strategy such as the use of spreads. The reason for the popularity of buying calls and puts and its variations is quite simple; limited or defined loss against the potential for unlimited and fabulous profits. This is what has driven thousands into the options trading game. But like everything else in life there is always a trade off. While the potential for fabulous profits against limited investment exists the reality of achieving such success is restricted. Itâs almost like buying a lottery ticket with the potential for winning fabulous riches. Or putting it differently, itâs also akin to going to a casino and placing bets on gaming tables with the hope that at the end of the evening you will come out with more money than you came in. As we all know there are very few winners in casinos and that is why the gaming business offers tremendous profits for the operators.

But one can be an option trader and be in a similar position as the casino operator. Â How? By being an option writer or seller instead of a buyer. For every option that is bought in the market, there must be a seller or writer of the option. These writers are the casinos in the options business. As the option seller you take the bets from the option buyers and since 75 to 80 percent of all options in the market expire worthless, you the seller pocket the premiums paid by the buyers when the options they bought expire worthless. For the benefit of those who are not familiar with gambling casinos, the winning odds of casinos over the betting player is only around 5 percent and yet they rake in profits from this business. Now imagine this, research and studies have shown that the option writer (seller) has better than 10 to 20 percent odds over the option buyer.

Option traders who successfully use the strategy of selling options consider themselves as having found the Holy Grail of Investments. And of all the variations in option selling strategies (just as many as there are in option buying), writing naked options is considered to be the Cadillac division. No other option selling system offers the profit potential of the naked writer.

So why arenât there more option writers in the market? For two reasons:

It must be noted however, that option writing is fast gaining popularity among serious investors looking to grow their wealth at a steady, consistent and secure manner regardless of market or economic conditions. For those willing to venture into this lucrative field for long term capital appreciation donât let the first reason above frighten you into inaction. There are many ways one can protect himself and conquer the element of âunlimited lossâ in writing nakeds. The author of this article is one of many successful naked option sellers. He has put out an e-book detailing a trading system that uses a three pronged strategy that trounces the so-called risk of loss to be almost neglible. Information about his system can be found at his web site.Â Â Â

Options Trading in Extremely Volatile Markets

admin — Sun, 10 Jan 2010 23:54:03 +0000

The recent stock market crisis (2008) not only rocked the financial system and the world economy but also the pockets of countless options traders all over the world. Options traders who used to profit in the years prior to this market crisis broke their bank as none of their options strategies seem to work in this market anymore. So what is it about extremely volatile markets and how should one profit through options trading under such conditions?
Extremely volatile market conditions not only produce unpredictable short term stock price swings but also open up the bid ask spread of individual stock options due to a lower liquidity and profiteering by market makers. This combined effect not only made it doubly hard for options traders to make a profit. Volatile options strategies, supposed to be meant for such conditions due to their ability to make a profit when the market moves up or down strongly and their ability to profit from an increase in volatility, also failed to produce any consistent profits due to the higher premium outlay and wide bid ask spreads, soaking up most of the profits. Unexpected rallies also crunch volatility to the extent of producing losses through decaying the premium of long legs at express speed. Short term (weekly, monthly) directional options strategies fared even worse as it not only became almost impossible to predict short term price swings but the high premium and bid ask spreads also took most, if not all, of the profits away even if the stock did move in the expected direction.
So what works in an extremely volatile market condition such as this one?
First of all, let’s look at all the different ways to trade options. There are 3 main options trading methodologies; Swing Trading, Position Trading and Day Trading.
Swing trading is a directional options trading methodology that aims to pick stocks that will move quickly and strongly within a short period of time in a predictable direction and then execute bullish or bearish options strategies in order to profit from these moves. As mentioned before, trying to profit from directional swing trading in an extremely volatile market is like swimming against the tide. Not only is directions hard to predict in the first place but the high options premium along with gapping bid ask spread all work against its favor.
Position trading is more complex than Swing Trading as it aims to profit mainly (although there are also position trading strategies that are directional in nature) from volatility or premium decay through putting together several different options and / or stocks in order to produce a hedged, market neutral position. Position trading has produced some pretty profitable results for me in this market crisis as volatility soared and options premiums are high. This puts the disadvantages of an extremely volatile market condition in the favor of the options trader. Such positions include dynamically hedged delta-neutral as well as delta-gamma-neutral positions. Both of these position trading strategies aim to neutralize market movement such that unexpected swings do not affect the position significantly while the position safely takes the high options premium on the short legs into your pockets.
Day trading is an extremely dynamic options trading method where options are bought and sold very quickly within one day in order to profit from the slightest intraday price swing or change in volatility. This strategy was a pretty hard one to profit from in low volatility market conditions as prices doesn’t change enough within a day to produce significant profits. However, day trading becomes extremely profitable in the hands of seasoned options trading veterans in extremely volatile market conditions such as this market crisis as the Dow itself has produced intraday trading ranges of up to 10%! Yes, this is the kind of trading range and price range that cannot be realized in normal market conditions. Day trading often takes the form of simply buying or shorting call or put options and then quickly covering them when profitable. Day trading also avoids the extreme overnight uncertainties that so often catch swing traders by surprise in this market crisis. Sudden overnight good news can often gap the Dow up by a significant amount and closing it over 10% higher. This can wipe out all your profits if you had been betting in the opposite direction overnight. Day trading, however, is extremely risky for beginners in options trading as the price movement is so fast and dynamic that when things happen, beginners may not know what to do and be able to do it quickly. This is therefore not recommended for beginners.
So, there you have, 2 ways to profit from this market crisis through options trading which I have used profitably. Options trading (http://www.optiontradingpedia.com) is definitely profitable under any market conditions as long as you use the right method for the prevailing conditions.

Option Trading Explained – In Layman Terms

admin — Thu, 07 Jan 2010 23:26:29 +0000

Robert Kiyosaki says that Option Trading is the investment of the rich.
Indeed, option trading is the most versatile form of investment in the world today. Its versatility has been the topic of many speakers all over the world. Terms such as “Covered Calls” and “Credit Spreads” have become well known amongst traders new and veteran alike.
Option Trading Explained – Simply put, it is the trading of option contracts on a particular stock.
Options Explained – A contract that allows you to sell or buy a stock at a predetermined price within a set time frame.
There is enough material written explaining the technical make up of an option and I shall not dwell into it further in this writing. The purpose of this writing is to explain to you what the effects of option trading is. … let’s go into Option Trading Explained!
Option Trading Explained – What Can Stock Options Do?
Let us first examine the effects of this thing called stock options. Knowing all the effects of stock options allows us to better understand why it is such a celebrated investment tool and also why so many people go bust doing it. Let’s start from the Positive Effects of stock options.
Stock Options are:
Leverage. It allows you to control more shares (100 shares per option) with the same amount of money thereby exponentially increase your returns per dollar.
Discount. Just as you control more shares with just one option, you will then be able to control the same amount of shares with lesser money than before.
Protection. It allows you to protect the stock you hold by owning the right to sell them at a predetermined price no matter what happens.
Regardless of market direction. It allows you to profit from both upward and/or downward moves in the stock.
Creative. It allows you to put different types of options together to form all sorts of investment positions. It can even make money no matter which way the market goes.
And the Negative Effects are:
No value beyond expiration. You can potentially lose all your money along with the expiration of the option.
Negative Leverage. Just like it can amplify your gains, options will also amplify your loses.
Time Decay Effect. Options reduce in value over time and sometimes can completely obliterate any gains from movement in the underlying stock.
Looking at the above effects, it is clear that Option Trading indeed is an extremely versatile investment tool that allows its investor to profit from any market direction, protect his/her stock positions, reduce capital commitment and lots more, based on the way it is utilized.
Conversely, once such power of leverage is being abused, the investor could then lose everything he/she have put in by expiration or lose more from the same stock move than he/she is comfortable with. Also, by holding on to Options, time decay sometimes can obliterate your profits if the movement in the underlying stock is not big enough.
Therefore, investing in options requires careful planning on the part of the investor. You must know for what effect are you using options for and how much you are putting at risk. In essence, using options for Leverage confers the highest risk and the highest rewards and demands that you use only proven strategies with a proven track record.
Using options creatively even allows us to structure investment positions to reap a fixed monthly return that beats the market regardless of which way the market goes! Just like in the Ride the Flow System offered at http://www.mastersoequity.com/MOE_ridetheflow.htm . Where your capital can be fully protected no even if the market enters a severe drop. Sounds amazing?
Option Trading Explained – Conclusion
I hope this “Option Trading Explained” has given you a good overview of the effects of options.
For a full and complete education in option trading, please visit http://www.mastersoequity.com/OptionUni.htm

Maximizing Option Trading Profits With Fast Puts And Calls

admin — Mon, 21 Dec 2009 11:59:06 +0000

In today’s chaotic stock market, the ability to make a profit trading long Option positions (Puts and Calls) depends on being able to capitalize on short-term moves in the price of a stock or index. Stocks are up one day, and down the next – and it’s anybody’s guess as to what the long-term outlook is. With the price action occurring on a daily basis being more or less a guessing game, the ability to make profits with long option positions depends on being able to buy options that can gain value quickly with a minimum amount of price movement in the underlying security.
In the past, figuring out which option might move the most quickly has been a guessing game. For every equity with options there are several options for each expiration month. In the case of options on Indices, such as SPY or DIA, there are literally dozens of option choices for each month. Clearly, figuring our which of those options will reach a particular target gain on your initial investment, just by looking at the list of choices, is basically a guessing game
The key to a winning Option Trading Strategy it to be able to sort out the relative behavior of all of those options, and find the ones that can make your target investment gain (50%, 100%, etc.) with the least amount of price movement in the stock. The availability of a new Spreadsheet that can analyze and display the behavior of the various option choices, and show clearly which options can provide the desired gains with the least amount of price movement in the stock, eliminates the guesswork.
This analytical spreadsheet provides a number of useful Metrics for characterizing the behavior and future value of options, but the most important are the price gain data in the Matrix displays, which give a visual impression of the rate at which the different options will gain value as the price of the stock or Index changes. This provides the tool for finding the options which gain value at the fastest rate.
The spreadsheet provides two Matrix displays: The first shows the behavior of the options based entirely on the effects of Delta and Gamma, which determine how the price of the options change as the Stock price changes. This set of calculations is most relevant when you expect a very quick move in the stock price – a situation in which time decay (Theta) does not play a significant role. The second Matrix adds to the Delta and Gamma effects calculations of the influence of both Time Decay, and Volatility (Vega). These two variables can be changed independently of each other.
The results of these calculations are illustrated below in two tables. The data in the tables are for Dollar Tree Calls. The first set of values shows the amount that each call will gain based on the increase in the value of DLTR stock shown in the top line of the table (DLTR Price Gain). To make the relative behavior of the different Options clear, each line of the Table shows only the two price gains which bracket the increase in the option Bid price that will allow each option to be sold for double the original price paid, (the Ask price). (The target value can be set to any desired multiple of the initial cost, not just 2x, as in this example):
DLTR @ $35.42, Price changes needed to Double the value of a Call:
Matrix 1 – Delta & Gamma only price gains:
DLTR Price Gain:___ $2.00__$3.00__$4.00__$5.00__$6.00__$7.00__$8.00
DQO CU_______________$1.48___$2.09
DQO CH_______________$1.09___$1.56
DQO CV_________$0.47__$0.76
DQO CI_________$0.31__$0.51
- – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – -
DQO EH_______________________$1.89___$2.45
DQO EV_______________________$1.56___$2.04
DQO EI________________$0.91___$1.28
DQO EW_______________$0.73___$1.03
(These tables are greatly abridged for publication, and many data columns are not shown.)
The second Matrix shows how these same options will behave at some time in the future and, optionally, with a change from the present value of Volatility (Vega). The number of days into the future, and the change in Volatility, are determined by user input, which allows the exploration of many different “what if?” scenarios:
Matrix 2 – Price Gains after 35 Days and with Volatility at 85% of current value:
DLTR Price Gain:____$2.00__$3.00__$4.00___$5.00___$6.00___$7.00__$8.00
DQO CU__________________* * *___* * *__$1.65___$2.53
DQO CH__________________* * *___* * *__$0.52___$1.28
DQO CV__________* * *____* * *__________________$0.43__$0.76
DQO C___________* * *____* * *__________________$0.18__$0.37
- – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – - – -
DQO EH_________________________* * *____ * * *___$1.58___$2.30
DQO EV_________________________* * *____* * *__________$1.50___$2.15
DQO EI___________________* * *___* * *__________$0.66___$1.06
DQO EW_________________ * * * ___* * *__________________$0.72___$1.06
In this second Matrix, the positions occupied by price gain data appearing in Matrix One are represented with asterisks (if they differ from the new positions), providing a clear visualization of the way in which the Options’ gains in value have been changed by the effects of Time and Volatility.
The Tables above show how an analysis of multiple options can be used to make choosing the fastest option to purchase for a trade a more systematic process. If we anticipate that DLTR is going to make a quick move upward in price over the next couple of days (perhaps because of an earnings announcement), then using the data from the top table we would buy either the DQO CV Calls, or the DQO CI Calls. In cases like this, where there are two choices for an option based on the fastest rate of price gain, there are other metrics, such as price gain to achieve break-even, which can be used to narrow the choice further.
Based on the results of the analysis, these two Calls should double in value if the price of DLTR stock rises by $2.00 – $3.00 over the next few days, as of the time this data was current (early February 2009). The DQO CU and DQO CH options, by contrast, won’t double unless the price of DLTR rises by $3.00 – $4.00. If we were expecting the stock to drop, then we would perform a similar analysis using the Puts for DLTR. This example illustrates the power of this strategy: Buying one of the two fastest options cold result in a 100% profit, after the price of the stock has risen by less than 9%!
On the other hand, if we expect that DLTR will rise gradually over the next several weeks, then we would use the calculations in the second Matrix. Setting the number of days to the expected interval for the trade (in this case, 35 days) and allowing for the likelihood of a 15% decrease in volatility for these options, the best choices for Call options to buy would then be either the DQO CU, or the DQO CH Calls. Note that these March calls will still provide a faster return than the longer expiration options (the the May calls), even though the elapsed time is 35 days. This is not always the case, however.
One of the advantages of the way this data is presented is that anomalies in Option pricing “jump out” at the user very clearly. In the second Matrix, notice that the price gain data for the DQO EI Calls are displaced one position to the left, relative to the DQO EW and DQO EV Calls. This indicates that the DQO EI calls have an advantage over the others under these conditions, and will produce a faster return.
The use of a trading strategy that takes advantage of analytical tools (like the price gain velocity analysis shown here) provides an opportunity to make trading decisions that are based on analytical data, rather than “gut instincts”. This provides Option Traders with a more systematic way to make choices when devising an Option trading strategy, and taking an Option position.

Options Trading and Risk

admin — Wed, 16 Dec 2009 11:36:17 +0000

Is options trading risky? This is one of the most popular questions that options trading beginners ask. In fact, my clients ask me this same question all the time. I would then ask them “What do you mean by risky?”. The usual answer would be “Can I lose a lot of money in options trading?”.
At least this brings us somewhere. Asking if options trading is risky without a clear idea what risk is in the first place gets nobody anywhere.
Risk is defined in many different ways to different people and for most people, risk is simply an expression of their fear of losing money. Whenever I am asked by an options trading beginner if options is risky, I know what they are really telling me is that they don’t want to lose money. How can we address this “risk” then?
Even though there are many ways to define risk in the financial sense, I think my 2 parts explanation caters best to the needs of the common retail investor. In my 2 parts explanation, risk in options trading for common retail investors are made up of; 1, Probability of Loss. 2, Consequence of Loss.
It’s like crossing a street. The probability of death is small but the consequence of death is catastrophic. However, because the probability is so small, we continue to do it every day.
In stock trading, you cannot really control the probability of loss because you win only if the stock goes up. That is why stock traders reduce the consequence of loss by having sensible stop loss in place.
See how the probability of risk and the consequence of risk interact with each other now?
The good news about Options Trading is that you get to control both the probability of risk and the consequence of risk! If you can control both elements of risk, won’t options trading actually be less risky than stock trading?
Options trading reduces the probability of risk through options strategies that profit from more than one direction. In fact, there are options strategies that profit when the stock goes up, down and sideways all at once! When you can profit in so many different directions all at once, won’t your probability of risk be dramatically reduced? An example of such an options strategy is the Call Ratio Spread which makes a profit if the stock goes up to a certain limit, stay stagnant or go down endlessly.
Options trading (http://www.optiontradingpedia.com) reduces the consequence of risk through leverage. Leverage cuts both ways. If you abuse leverage and buy options like you buy stocks, then you are in big trouble. However, if you use only money you can afford to lose in each options trade and make use of its leverage to produce the same returns that you would if you have bought the stocks instead, won’t the consequence of risk always be within your acceptable limit? An example of this is the Fiduciary Call options trading strategy.
Since the probability of risk and the consequence of risk can be dramatically lower in options trading than in stock trading, is options trading still “risky”?
Risk can be defined in many ways and options trading is inherently risky due to its nature as a leveraged derivative instrument. However, with sensible control of the probability and consequence of risk, your options trading experience may be a lot less “risky” than you think. Options trading becomes “risky” when you lose control over these 2 critical elements.

Balance of Risk and Reward in Options Trading

admin — Fri, 11 Dec 2009 11:49:00 +0000

You don’t need to be a trader or an investor to know that the higher the risk, the greater the reward. This concept is true in all aspects of life and business. The more risk you are willing to undertake in life, the more life returns to you. Indeed, risk and reward are directly proportional and often in trading and investment, the more risk your account is exposed to, the greater the return on investment when things work out as planned.
Knowing that risk and reward are proportional makes finding the correct balance of risk and reward extremely important to all kinds of traders; stock traders, futures traders, options traders etc. There is no one solution that works for everyone and the correct balance is decided upon the risk appetite and risk tolerance of the individual trader.
For stock traders, balancing risk and reward primarily involves adjusting the amount of growth stocks and defensive stocks in one’s portfolio. Generally, the more growth or speculative stocks in one’s portfolio, the greater the risk due to greater uncertainty and therefore the higher the gain when things works out as expected. The more defensive stocks in one’s portfolio, the more predictable returns become and therefore the lower the return as these stocks does not generally move a lot. This degree of risk / reward balancing is at best crude compared to the surgically fine degree of balancing you can have in options trading.
Stock options are the most versatile trading instrument in the world right now due to the wide array of options strategies that are employable. Yes, not only can risk and reward be balanced through employing different mix of strategies in your portfolio, there are also different risk and reward profiles achievable by each individual options strategy. There are options strategies that range from making over 1000% profit while risking all your money to options strategies that make a mere 0.01% return while risking nothing as well as every centimeters in between.
As long as you understand what your personal risk appetite and risk tolerance is, you will be able to find an options strategy that suits your needs 100%. Here’s a general outline of the kind of risk reward balance that can be achieved through options trading:
Highest Risk, Highest Reward – OTM Call / Put buying
This is the options strategy that produces the legendary 1000% profit that amazed so many beginners. What those ads did not tell you is that the risk is losing ALL the money that you put into the strategy. This options strategy involves buying out of the money(http://www.optiontradingpedia.com/out_of_the_money_options.htm)call options when you think a stock is going to go up or buying out of the money put options when you think a stock is going to go down. Professionals use this options strategy with only a very small portion of their money in order to place a bet on an uncertain event such as leveraged buyout. Some lucky amateurs use this options strategy with all their money and then become millionaires overnight. The downside of this strategy is the fact that if the stock did not move far enough in the direction you expected it to, you can lose all the money you put into the strategy. That is also why so many beginners break their accounts overnight in options trading.
Various Degrees of Risk and Reward – Options Spreads
There are literally hundreds of possible options spread strategies out there with various degrees of risk and reward for every market condition. There are more aggressive bullish, bearish, neutral and volatile spreads and there are more conservative ones. All of them shares the same logic of higher risk compensated with a higher profit potential.
Lowest Risk, Lowest Reward – Options Arbitrage
Yes, there are literally risk free trading opportunities in options trading which also returns very small, sometimes negligible returns. These are the legendary options arbitrage strategies. Options arbitrage strategies such as conversion/reversal aims to make a fixed return totally risk free through simultaneously buying the underlying and shorting the overpriced synthetic equal or vice versa. The problem with such strategies is that the returns are so low that most of the time, it’s even lower than the commissions you will pay for the trades made. Even if you manage to return a positive return, the return can be as low as 0.01% in percentage terms. That is why arbitrageurs aim to make an absolute return using enormous amounts of money.
With this in mind, the most conservative traders may choose to specialize totally in arbitrage strategies (http://www.optiontradingpedia.com/options_arbitrage.htm) while the most aggressive traders may choose to specialize in leveraged speculation using OTM options. Everyone else would be able to find something to suit your risk appetite in the hundreds of spread possibilities. This degree of flexibility and range of risk/reward possibilities makes stock options the most versatile trading instrument in the world today and why options trading (http://www.optiontradingpedia.com) is so popular these days.

Long and Short Butterfly Trading

admin — Sun, 29 Nov 2009 12:51:43 +0000

The Butterfly is an option position that is composed of 2 vertical spreads that have a common strike price. In other words, butterfly trading involves an opening position where options (either calls or puts) are bought (or sold) at 3 different strike prices. The way in which these options are created makes the butterfly a position that has both limited losses and limited profits.The Long Butterfly can be created using either all call options or all put options. Due to put-call parity, a long butterfly created using call options will behave like a long butterfly created using put options. In other words, it doesn’t really matter whether you use calls or puts to create your long butterfly. Our example here will focus on the version using call options.The long butterfly can be created by buying an In-the-Money (ITM) call option, selling 2 At-the-Money (ATM) call options and buying another Out-of-the-Money (OTM) call option. This is actually a combination of 2 opposing vertical spread options, hence why the butterfly is also known as the butterfly spread.Combining the profit profile of these 4 call options, you will find that if the stock price falls, you will face limited losses (which is the initial premium you paid for the entire butterfly trade). Similarly, if the stock price climbs too high, you will also face limited losses. However, if the stock price stays around the vicinity of the ATM option strike price, you will receive limited profit.This makes the long butterfly a good neutral option strategy for low volatility, since you are betting on the stock price not moving much in order to collect maximum profits. It is also a low-risk strategy, since your losses are limited if the stock crashes or climbs unexpectedly. Unfortunately, this is accompanied by limited profits as well. As has been mentioned above, the long butterfly can also be created using all put options instead of all call options.A Short Butterfly is the exact opposite of the long butterfly. Instead of buying an ITM call, selling 2 ATM calls and buying an OTM call, a short butterfly is constructed by selling an ITM call, buying 2 ATM calls and selling an OTM call. As before, the short butterfly can be created using all put options instead of all call options.The short butterfly’s profit profile is the opposite of the long butterfly’s. If the stock price falls, you will receive your maximum limited profits (which is the initial credit premium you received when opening the short butterfly position). Similarly, when the stock price climbs, you will also receive limited profit. However, if the stock price doesn’t change much, you will face a loss, though that loss is limited as well.As can be seen from the above description, the short butterfly is meant to be a strategy that is high in volatility but neutral in direction (ie. you expect the stock to move a lot, but do not know in which direction). As a side note, this might not be the best strategy for you if you are indeed expecting high volatility and are uncertain in stock price direction. Both the Straddle and the Strangle strategies also have the same lean towards high volatility and neutral direction, but with the extra benefit that they have the potential for unlimited profit. However, the benefit of the short butterfly is that it is a credit position where you pocket the initial premium when creating it.One warning about both long and short butterfly trading: these positions involve buying and selling options at 3 strike prices. For most option brokers, this means you will be paying 3 commissions to open the position, and another 3 commissions to close it. You will need to consider these extra commissions (which differ from broker to broker) when trying to determine if the butterfly will be profitable for your circumstances.For a more detail and illustrations on butterfly trading, please visit: http://www.option-trading-guide.com/butterfly-trading.html