by Lawrence Meyers | March 26, 2013 9:25 am
Their silly names withstanding, there are some really great option strategies out there providing income with limited risk. They can be a bit complex, but done correctly, they offer a very nice way to supplement monthly income.
The iron butterfly is known as a “spread” and offers up limited risk and a limited profit. Unlike many option strategies I like that depend on high volatility, this one assumes the stock you’re looking at has low volatility.
In other words, it’s boring.
In an iron butterfly, you buy a lower-strike out-of-the-money put, sell a middle-strike at-the-money put, sell a middle-strike at-the-money call, and buy a higher-strike out-of-the-money call. Done correctly, you will see a net credit.
What you would like to see happen is that your stock is essentially ignored by the market. Large-cap blue-chip stocks can be good for this, particularly ones that pay a dividend. You’ll see the maximum profit if the underlying stock price, at expiration, is equal to the strike price at which the call and put options were sold. At this price, you cheer as all the options expire worthless, meaning you get to keep all those juicy premiums less commissions.
How much can you lose here? Not much — and that’s why I like this choice. Your maximum loss occurs when the stock price falls at or below the lower strike of the put purchased, or rises above or equal to the higher strike of the purchased call. Either way, your loss is equal to the difference in strike between the calls or puts, after backing out the net premium received when entering the option trade.
You also could break even. That will occur if the stock is at the strike price of the short call plus the premium you got, or if the stock is at the price of short put, less that premium.
These multi-leg options are always easier to understand if we use a real example.
As I write, Coca-Cola (NYSE:KO) trades at $40.12.
Buy APR 39 Put for 22 cents
Sell APR 40 Put for 53 cents
Sell APR 40 Call for 65 cents
Buy APR 41 Call for 23 cents
Your total purchases are 45 cents. Your total sales are $1.18. Your net credit is 73 cents. So, based on contracts of 100, that’s $73, less commissions.
In situations like this, I try to execute bulk trades of at least three sets of options to lessen the commission impact. That would lead to about $219 in premium on $12,036 in underlying stock, or a 1.73% return for one month. Very nice.
On expiration in April, if Coke stock is still trading at $40, all the options expire worthless and you get your maximum profit. If Coke is at $39, all options except the APR 40 put expire worthless, which you must buy back for $1. You have a 27-cent loss plus commissions. The same thing happens if the stock hits $41, just in reverse.
The great thing about blue-chip stocks is there are many expiration prices available, so if you think $1 is too close, you can use larger spreads.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets @ichabodscranium.
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