Welcome to Part 13 of my series of articles on the Butterfly. In last week’s article we began to look at some ways of searching for and constructing a standard Put Butterfly on the SPY (exchange traded fund of the S&P 500). To learn details of the search, please refer to Part 12. Below in Chart 1 are our trade search results, and we’re going to begin with narrowing down our search results.
click to enlarge
The first area I may look at is the days to expiry, under the column Days. Ideally we would want our Butterfly to have 30-45 days to expiry. Two of the results here are 66 day trades. In trades this long, you’ll find the Butterfly won’t start working its ‘magic’ for another month or so, until it reaches the approximate 30 days to expiration time. Given this, let’s throw out the first two results in the table above.
Leaving trades 3 and 4 from the results table, I would then look at the Max Risk of the trade. In the case of a standard, unmodified Butterfly, the Max Risk is also the cost of the trade, or Entry Debit. Trade 3 costs $128, and trade 4 costs $140. The first question I would ask myself here is why is one Butterfly cheaper than the other?
The closer to ATM (At-The-Money) the Butterfly is, the more expensive it is. Also the more probability you have of making some money because the stock price is directly at the mouth, just waiting for time decay to start working its magic. The further Out-Of or In-The-Money the Butterfly is, the cheaper it gets – it’s an exact trade off with probability because the stock may then have to move a little or a lot in one direction for the trade to make some money, depending of course how far away the mouth area is.
With the SPY currently at 107.22, the trade costing $140 consists of selling the 108 puts as the body, so really 78 cents (x2) of this is just intrinsic value. (With the stock at 107.22, 108 puts are 78cents ITM, 108-107.22 = 78, and we sell 2 of them in the Butterfly, therefore 2x 78cents). The $128 trade consists of selling the 107 puts as the body. As the 107 puts are OTM, we are selling all time value.
One important concept to be aware of is that the cheaper the trade is, the more profit potential it has (all else being equal). Have a look at the results table above: The $128 trade has a profit potential of $371, and the $140 trade, more expensive, only has a trade profit potential of only $359. Why wouldn’t we always go for the cheaper one, or even construct a Butterfly costing only $30, which would have a profit potential of $470? A very good question! It’s all about a mix of risk, reward and probability. Next week we will continue to look into this more.
Manage your trades!