Butterfly Spreads Grab Options Premium

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Option traders should keep in mind that there are distinct periods within the options expiration cycle where certain trades work better and give a competitive advantage to the trader who recognizes and takes advantage of this seasonal pattern. This is one of many options trading articles in InvestorPlace Media regarding strategies such as butterfly spreads.

Option cycles historically have been established with monthly expiration cycles. For the knowledgeable option trader, different time periods within this monthly cycle are known to have distinct characteristics. The primary reason for these characteristics is the “non linear” decay of time premium. This means that the decay of time premium accelerates as expiration approaches.

The butterfly is one of the option constructions most affected by seasonality. The last two weeks of the monthly option cycle is even called “butterfly season” by many option traders. The classic behavior of butterflies is that they are only slightly impacted by changes in the price of the underlying early in the cycle and exhibit increasing response to price change late in the option cycle. This has frustrated many traders who have tried to employ butterflies early in the cycle and have routinely seen the correctly predicted price action result in minimal or no profit in the position.

First and foremost, we need to be aware of our position in the cycle. The Feb options expire Friday, February18 — 15 days from today, so we are close enough to the mid-point of the cycle to be open season for butterflies.

The essential structure of a butterfly is to establish a spread in either calls or puts that has the structure +1/-2/+1. The spread uses options which all expire in the same month. (A variant, the iron butterfly, uses both puts and calls but this metallic beast will need to be the subject of another post.)

Let’s look at an example of a butterfly structure before we discuss some of its nuances. The trade is that of a put butterfly in the iShares Silver Trust (NYSE: SLV). This is only an example and not a trade recommendation or financial advice. It is to demonstrate the butterfly structure and to lead us to some functional considerations.

iShares Silver Trust (NYSE: SLV)

The position is slightly bearish with maximum profit occurring at expiration at the SLV price of 26. For those who are bullish or even neutral, a similar trade could be constructed to reflect that viewpoint. Notice the difference in the solid blue line, the expiration P&L graph, and the intermediate time frames indicated by the broken lines. As is readily apparent, the sensitivity of the position to price movement is much less at points in time prior to expiration.

When trading butterflies the maximum profit is ALWAYS when the price of the underlying, in this case SLV, is at the short strike at expiration. By remembering this fundamental characteristic, an option trader can center the butterfly on his projected price target in order to maximize profit.

Another fundamental characteristic of the butterfly construction is that this structure usually works best in an implied volatility (IV) environment that is in the upper half of its historic range. That’s because the options we sell short in the center of the butterfly represent a major profit engine for the structure. If these options are somewhat “rich”, as indicated by the calculated level of IV, they provide a substantial boost as the time premium we are short decays into expiration.

How does the butterfly under discussion fit into the volatility consideration? Below is the volatility chart for SLV. The brown line is the volatility actually demonstrated in the market recently, and the blue line is the IV calculated from actual option trades. We are currently in the mid range of volatility for this underlying. This is a good place to be for an options trade, and provides an additional “tailwind” for the trade together with our current position in the time of the option expiration cycle.

SLV Volatility Chart

Successful option traders understand the limitations and advantages of the vehicles available to them. The butterfly can deliver outstanding risk/reward scenarios, and the probability of its success is enhanced by understanding the nuances of its use.

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Article printed from InvestorPlace Media, https://investorplace.com/2011/02/options-butterfly-spreads-slv/.

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