Welcome to part 8 of a new article series on one of my favourite strategies, the Butterfly. In this week’s article, we will continue looking at the Risk Graph page in a lot more detail. We will work with the same Butterfly we have been working with throughout the series, the AAPL (Apple Computers) Oct 09 155|175|195 Call Butterfly. At the time we constructed the trade, AAPL’s price was about $173, so this would be known as an ATM (at-the-money) Butterfly, because the short (sold) strikes are ATM. Let’s have a look at the top part of the Risk Graph page, with the trade leg details, trade cost/risk amounts etc, and Greeks. In the last article we looked at the columns Option Symbol, Expire, Strike Type, Entry and Bid/Ask.
click to enlarge
We will continue now where we left off. In the trade legs, let’s look at the 9th column from the left, named Model. The Model quote is the price the option should be ‘theoretically’, based on the particular Options Pricing Model used. This is not necessarily the price the option is trading for. In fact in reality if you want to trade this option, the price of it will be that set by the market, not by an Options Pricing Model. However, looking at the Model can give you an idea of whether the option is under or overpriced.
For example with the 195 call, with its model at $1.253, if the Bid/Ask was $1.50/1.60 the option would be heavily overpriced, perhaps because of a huge rise in IV, which may be reason not to trade it. So, as long as the Bid/Ask’s are in the league of the Model and not too far over then they should be ok to trade. I know the question prevails – how much over it is too far? But think of this – we are selling options here too, so if the 195 calls are overpriced, the 175 calls most probably will be too, which is a great thing for us as option sellers. Even so, they should be overpriced ‘higher’ than the 195’s, because the 175’s are ATM, and time value (the premium in an option) is greatest ATM. So make sure you consider the whole picture.
The next column across named IV tells us the individual Implied Volatility levels for each leg. In the IV chart below the risk graph (not shown in this article), the IV levels are an average whereas here we have the exact IV for each leg. In analysing the trade I don’t interpret the number or their differences in any way – I would have studied IV in the IV chart as a whole before constructing the trade and assessed whether it was low or high, overall.
The column to the right of IV titled IV Vary is simply allowing you to enter different IV levels to simulate how an increase or decrease in IV would affect the trade. The process or ‘rushing’ or ‘crushing’ IV in a trade can be quite advanced, which is why we go into it in depth in the ICT class.
We will continue with the Risk Graph analysis in the next part of the series.
Manage your trades!