Welcome to part 4 of a brand new series on one of my favourite strategies, the Butterfly. In this weeks article, we will be looking at how to deal with the Butterfly on Expiration day. Expiration day for stocks in the US market is the 3rd Friday of the month. For some ETF’s or Indices it may be the 3rd Thursday of the month.
Lets look at some of the risks that Expiry could bring us, if we held the Butterfly right through to expiration. Let me say at the outset that the risks here could apply to any strategy. The market doesn’t know whether you have a Butterfly on, or just on short put for example. We are going to be looking at some of the risks that could happen to our options in general, whether the option be a part of a Butterfly, or another strategy.
The first and foremost thing we have to work out is which options are In The Money, and which are Out Of The Money. We also need to take a view on the stock for that last day. Our view may be that the stock will finish in a place allowing certain options to expire either ITM or OTM. If we don’t have a particular view and the stock is sitting on the fence, going ITM and OTM constantly around a strike price, we must be prepared for either scenario.
The first, most common, and also cleanest way to deal with the Butterfly on expiration day is to simply close the trade. This way there’s no assignment risk. You wont make that max profit if the Butterfly was floating around the short strikes, but we shouldn’t be aiming to hit this anyway. A Butterfly on expiration day or a few days before expiration, that is trading very close to the strike price, would have such high Gamma it may not be worth staying in, because a small move up or down could bring the stock back out of the mouth and we would lose the profit we had just made. So again if in doubt, close the trade. In any scenario, if you don’t know what you’re doing or what your risks are, you shouldn’t be in the trade at all. Bear in mind when closing the Butterfly to check the bid / ask of the Butterfly. If its wide you may pay too much in slippage closing it at the market price, so use a limit order – (You may have to pay more than you would normally offer in a debit strategy, as there are a lot of legs involved).
Lets continue with our example of the AAPL (Apple Computers) Oct 09 155/175/195 Put Butterfly. In the risk graph below the trade still has 38 days remaining until expiry, but for the sake of the exercise, lets pretend that we were just 1 day from expiration, the coloured lines aren’t there, and we are just dealing with the black expiration line !
We’re going to go through some scenarios of the Butterfly expiring totally OTM, totally ITM, or part OTM and ITM.
click to enlarge
click to enlarge
As this is a Call Butterfly, if the stock closed at expiry lower than the lowest strike price in the fly, all legs would expire OTM and worthless. You would lose the debit you paid for the fly. If the stock closed at expiry higher than the highest strike price, the whole trade would expire ITM, all legs would be assigned or exercised and cancel each other out, and again you would lose the debit you paid for the fly.
The opposite applies for a Put Butterfly. If the stock closed at expiry higher than the highest strike price in the fly, all legs would expire OTM and worthless. If the stock closed at expiry lower than the lowest strike price, the whole trade would expire ITM, all legs would be assigned or exercised and cancel each other out, and again you would lose the debit you paid for the fly.
In the chart above, AAPL is trading at $172.93. For our expiration example, lets see what would happen if APPL actually expired here at $172.93. In the example of a Call Butterfly (that we have here), the $155 Call would expire ITM, the 2x $175 Calls would actually expire OTM, and also the 195 Call would expire OTM. At expiry the 155 Call would be exercised. As you own a Call here, and have the right to buy shares of Apple at $155, you would then become long 100 shares of AAPL, at $155, that are now worth $172.93. Great profit! The rest of the trade will expire worthless, but be aware that you now have a new trade – you have 100 Apple shares ! Either protect them straight away or sell them ! Realise that if AAPL then went down, you would lose potentially more money than the original debit of the Butterfly, because you are in a new trade now, with a new risk profile.
Finally lets look at the scenario where the stock closes very close to the 2 short strikes, but so that they expire a little ITM. Using the above example lets look at a scenario with the stock closing at $176. In this example, we have the 2 shorts and the lower long leg all expiring ITM, and the upper long leg expiring OTM. As far as exercise and assignment goes, the lower long leg and one of the short legs would assigned cancel each other out. This part is just an ITM Call spread (Bull Call Spread) that is expiring ITM, so it will be assigned, and the profit left in your account. But we still have one short leg unprotected that is expiring ITM. The assignment of this short leg is going to result in short stock, so on Monday morning (if only exercised at the very end of Friday) you will have 100 shares of short stock – a brand new trade with its own risk and reward profile. You will want to manage this quickly by buying the stock back to close the trade, or protect it somehow.
Manage your trades !