Tag Archives | option strategy

Ratio Spreads: Part IV. Broken Wing Butterfly

The first three posts in this series on ratio spreads (Part I, Part II, Part III) were published recently.

The broken wing butterfly spread (BWB) is a frequently used strategy for more experienced players.  Today I'll introduce that option strategy to readers of Options for Rookies.

In general, any butterfly spread is used when the trader wants to forecast a specific price range for any underlying.  It's also created as an adjustment for existing positions (as a risk management play to limit losses or lock in profits).

In the scenario under discussion (ratio spreads) the BWB is constructed to limit losses, always a good idea when trading options.  Buying options that are relatively far OTM is not done to 'take a shot' at a gigantic market move.  Instead the trade is made to convert a position that is already short naked calls or puts (a ratio spread) into a position that is no longer short any options.  In fact, You can always buy an extra contract or two to provide an unlikely, but nice profit when the market makes an unexpected large move.  If this concept is not obvious, that's not a problem.  Use your broker's graphic software to examine the risk picture. Do not forget to look ahead and examine risk one day prior to expiration.

The BWB differs from a traditional butterfly spread as follows:

Butterfly spread: A trading strategy consisting of the sale of two options, along with the purchase of one option with a higher strike price, and one option with a lower strike price. Necessary conditions:  All options are of the same type (calls or puts); the options owned are equidistant from the options sold, all options expire on the same date

Broken wing butterfly (BWB): Same as above, except that the options bought must NOT be equidistant from the options sold.

Although these positions frequently stand on their own, they can be traded by conservative investors who would like to trade ratio spreads, but who refuse to own positions with any naked short options.  The BWB comes to their rescue.

 

The ratio spread

Let's say you are bearish on the market and want to make a trade that suits your expectations.  Your guess is that the market will fall, but not too far.  With RUT (Russell 2000 Index) trading near 673, you decide to Buy 3 RUT Jan 650 puts (@ $8.20) and Sell 6 RUT Jan 630 puts (@ $5.70).  This is a 1 x 2 put ratio spread, and you collected a credit of $3.20 for each spread. [Most rookie traders think of this as collecting $960.  However, that makes the conversation awkward.  It's far easier to refer to this spread – as well as any other – in terms of its lowest common denominator. That's 1 x 2 in this example]

As discussed in talking about break-even points for ratio spreads, when the market moves too far, you may lose a significant sum.  I know that you (the person making this trade) really believe the market can move through 650 – that's why you bought the 650 puts.  You also believe it will not decline beyond 630 – and that's why you sold the 630 puts.

However, if your are correct about direction, but very wrong about magnitude, there is no reason to lose a lot of money.  This trade is naked short 3 puts, and that leaves you exposed to a gigantic loss if and when there is a big market collapse.  Why take that risk when it's unnecessary? 

If you take the more conservative approach, you can buy some Jan puts and accomplish two things

  • Limit losses
  • Allow you to maintain a cash credit for the whole trade
    • Allows you to earn a profit, even when wrong – and the market does not decline

You can buy RUT Jan 590 puts @ $3.  Or you may choose to save a bit more cash and take a bit more downside risk by buying a put with a lower strike price.

Such a trade turns your ratio spread into a broken wing butterfly spread.  You would own 'a 3-lot' of the BWB:

Long  3  RUT Jan 580 puts
Short 6  RUT Jan 630 puts
Long  3  RUT Jan 650 puts

Maximum loss occurs when RUT is below 580 at expiration, and that loss is $3,000 [per BWB] minus the credit collected when opening the position.

Why $3,000? [$9,000 total].  With RUT settling below 580:

The 650/630 put spread – and you own that one – will be worth its maximum, or $2,000.

The 580/630 put spread, which you are short – will be worth $5,000

 

There are two main ways to earn a good profit from this spread:

a) Expiration arrives and RUT is well under 650 but above 630.  This is the risky way to play because the Jan 630s would have a good deal of negative gamma (and lots of positive time decay) as expiration day draws near.  I don't recommend holding to the end, because this is the highest risk and highest reward play – and many traders are tempted to hold and hope.  I much prefer the next method (less reward and substantially less risk).

b) Hold the position long enough that theta works its magic and erodes the price of the options.  You hope to see the market undergo a slow decline, increasing the value of the Jan 650 puts that you own, but not far enough to offset the time decay in the Jan 630 puts.

Under those conditions, you exit the trade, collecting more cash.  The profit potential is very dependent on how much time has passed, the current price of RUT, and the implied volatility of the options.  In other words, to estimate a profit, you must use an options calculator. 

One good method for establishing a rough idea of when to exit the BWB is to make a trade plan just before or after making the initial trade.  That plan sets your (flexible) profit goals, as well as the maximum loss you araae willing to accept.  Those targets make the exit decision easier – especially for the less experienced trader who may be encountering specific situations for the first time.

When the broken wing butterfly works well, deciding when to exit requires discipline.  It's always going to be tempting to wait 'just one more day' to collect that time decay.  However, the risk of a big move exists as long as you hold the trade. 

One major warning: don't ignore risk. If RUT approaches 630 far too early for your comfort, then risk of loss mounts (in fact your trade is probably already under water).  Sure, losses are limited, but that is no reason to own a risky position.  The thought process is similar to trading any limited-loss strategy, such as the iron condor.  Prudent investors take losses – by exiting, or adjusting, the trade – to prevent the occurrence of large losses.

 

The BWB is a stand-alone trade that gives the trader protection against unlimited losses while providing a very good profit when that trader is correct in his/her market forecast.  This forecast involves more than direction.  In other words, it's not the best choice when very bullish or very bearish.

This post provides the general idea of what a broken wing butterfly is and how it can be used to minimize risk whenthe trader owns a ratio spread.

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Collars: Revisited

It's time to take a fresh look at collars.  In mid-2008, we wrote about collars and how they work.  As a reminder, a collar position consists of owning 100 shares of stock, one (almost always an out of the money) put option, and being short one out of the money call option.

The purpose of owning this position is to limit losses when the market falls.  The trade is slightly bullish and there is limited upside profit potential.

This is one option strategy that is preferred by those who want to protect their holdings from a devastating market decline.  It's very effective because losses are limited (the collar owner maintains the right to sell shares at the strike price of the put he/she owns).  There are two reasons that this type of portfolio insurance is so appealing:

  • It almost always costs no cash out of pocket to own the collar.  That's true when the investor collects as much cash when selling the call option as it costs to purchase the protective put option
  • This position provides both safety and the opportunity to earn a limited profit.  Investors who only buy puts must pay the heavy cost and have little chance to earn any money, unless there is a significant rally

Experienced option traders are probably aware that owning the collar is equivalent to two other positions, each of which is a popular strategy on its own.  However, many novice traders do not recognize that they may be trading collars in a different format:

  • Selling an OTM put spread
  • Buying an ITM call spread

Example (this is an example and NOT a recommendation) 

The Traditional collar:

Buy 100 shares of AAPL, paying $300 per share [$300 is not current price]

Buy one AAPL Dec 280 put

Sell one AAPL Dec 320 call

Sell the put spread – the equivalent position:

Buy one AAPL Dec 280 put

Sell one AAPL Dec 320 put

Buy the call spread – the equivalent position

Buy one AAPL Dec 280 call
Sell one AAPL Dec 320 call

For each of these three trades:

Maximum profit occurs when AAPL is above 300 at expiration
Maximum loss occurs when AAPL is below 280 at expiration

Profit and Loss are the same for each of the three positions when the options are priced efficiently.


So What?  Who cares?

I approve of collars.  I believe they are an appropriate strategy for protecting a portfolio.  However, I know that some people adopt strategies without understanding how they work.

The point that I want to make today is that the collar looks good – and is good for the appropriate investor/trader.  However, many people who adopt collars would never sell a put spread nor buy a call spread.  Yet, they are making the identical trade.  It's important to recognize what you are truly trading.

Some collar traders would be better served by adopting one of the alternative strategies.  The margin requirement is low and trading a position with two legs is far more cost efficient than trading one with three legs. I suggest that collar traders make an effort to trade the corresponding call or put spread in place of the collar.

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Abandoning your favorite option strategy? Reconsider

An excellent post by Jared at Condor Options was also picked up by Abnormal Returns. [If you are not familiar with the work of Tadas at Abnormal Returns, it's worth the visit.  He finds the best blog posts, and it's more than I can find time to read.]


Jared suggests treating a strategy as you would a favorite stock: Buy on dips:

"If you’re trading a strategy with a long-term record of solid
performance… a great time to increase
your exposure to that strategy is after the strategy has suffered a
losing period.

In other words, given a strong and consistent strategy,
you should buy that strategy on the dips."

That is an interesting suggestion based on mean-reversion.

When investing, and more often when trading, we tend to buy on dips.  We remember price levels at which we had previous success when buying a certain stock. Technical analysts consider this practice to be 'buying at support.'  It makes sense.

However, I confess that I've never done that.  When a strategy is not working well, I tend to cut back, rather than expand position size. 

"A strategy that has performed well over the long run should never be
abandoned after a decline, unless there is overwhelming evidence that
something about markets or the strategy has changed so fundamentally
that the strategy will never work again."

When there is a solid, fundamental reason for abandoning a strategy, then do it.  But when the decision to change strategies is based on an expectation of further losses (with no solid basis for reaching that decision), that's an emotional decision.  Jared goes on to say:

"Based on my own experiences mentoring and educating option traders, I
think that the most important factor differentiating unsuccessful
novices from those who survive long enough to become experts isn’t that
the latter group knows more about the option Greeks, or is better able
to analyze implied volatility, or anything like that. The decisive
factor, as trite as it sounds, is that successful traders are willing to
base decisions on information rather than emotion
."

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Visit the new Options for Rookies Home Page, with links to new material, including my thoughts on an options education.

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