| Matt Baker
Welcome to Part 16 of my series of articles on the Butterfly. In this week’s article we are going to look at the Greeks of the Butterfly case study we looked at in Part 15. The case study in Part 15 was taken from LiveTrade. www.optionetics.com.au/livetrade7days/
Chart 1 and 2 show the Platinum risk graph for the Call Butterfly on HES at the time of inception. The Greeks are the trade’s sensitivities to the different factors that can influence option prices – Directional movement, Implied Volatility movement, and Time decay. The Greeks can be found in chart 1 – Delta, Gamma, Vega, and Theta. For a comprehensive revision of what the Greeks actually mean, please refer to Part 1 of my series on the Greeks entitled: The Greeks and Their Mystery Unveiled: Part 1. www.optionetics.com/market/articles/19033. Please read this article first if you don’t understand the meanings of Delta, Gamma, Vega, and Theta.
click to enlarge
click to enlarge
Let’s look firstly at the Delta of 6.05 in chart 1. We may have heard before that a Butterfly is a Delta Neutral strategy, meaning we would want to start the trade with the Delta as close to ZERO as possible. This would apply if our prognosis on the stock was it would trade exactly sideways. But in this trade, our prognosis is actually mildly bullish – we think the stock will go up just a little from $62.55 where it is at inception, to $65 over approximately the next month.
Given this prognosis, if we traded with a simple Long Call, the option may actually lose us some money even if the stock goes up. We might find that by staying in a Long Call position for a month with such little upward movement happening, the option suffers from Time Decay more than it gains profit from its upward movement. A Butterfly could certainly be a better strategy to implement here because time decay is on our side.
The Delta here of 6.05 is simply telling us we’re going to make $6.05 for the next $1 in price movement that HES trades up. We would also lose $6.05 if HES went down $1. So the reason we constructed the Butterfly with a Delta of 6.05, and not ZERO, is because we were mildly Bullish in our prognosis – we want to make some money if HES goes up! If Delta were neutral in this Butterfly, we would actually lose some money if the stock went up. How did we construct the Fly with a positive Delta rather than Delta neutral? Simply we placed the Fly a little Out-Of-The-Money, and placed the body (the short strikes) at the point where we thought HES would head to, which was $65.
The Interactive Options Trading Class (IOT) goes into the Greeks a lot more than we have the scope to do here. I encourage every student to attend the IOT as early as they can in their trading, so they can get a handle on the Greeks and a deeper understanding of trade management.
Manage your trades!