Time decay and the loss of option premium is a fact of life for option trading investors. The winning traders will learn how to take advantage of this, especially as expiration week arises and the time value in option premium decays rapidly.

However, in some cases time decay can be a wind at your back as the time premium relentlessly goes to zero at the closing bell on options expiration Friday. I used a butterfly spread on active equity to profit handsomely last week.

Take Netflix (NASDAQ: NFLX). It has huge open interest (OI), tight bid/ask spreads, and tremendous daily volume, the best qualities of an underlying for option traders.

Last Monday of February expiration week, NFLX gapped up and reached an intraday high of $247.55, an all time historic high for this stock.

The rapid price rise resulted in a volatility spike with the at-the-money options seeing its implied volatility (IV) rise from 34% at market close Friday to an IV of 44% at market close Monday. Keep in mind, many option traders consider that IV is inversely correlated to price. But the change in IV in NFLX demonstrates the more accurate view that IV is more closely correlated to the velocity of price change.

Netflix Volatility

Because I felt the stock rise was not sustainable I initiated a high probability trade called a put butterfly spread constructed with a bearish directional bias.

A put butterfly spread involves three strike prices and offers limited risk and limited reward. A long put butterfly is created by buying one put at a high strike price, selling two puts at a middle strike, and buying one put at a lower strike. In this case, I bought 6 NFLX Feb 220 Puts, sold 12 NFLX Feb 240 Puts, and bought 6 NFLX Feb 260 Puts.

The essence of the trade was twofold:

1. I expected downward movement in the price of NFLX.

2. I expected a dual impact on the time premium sold within the butterfly.

I figured that the time premium would experience decay heading into expiration and that IV would decrease as NFLX stock price rise slowed. The structure of the trade implemented Monday afternoon and its expected P&L behavior is graphed below.

NFLX Put Butterfly Spread

Pay particular attention to the lowest broken line; this represents the P&L characteristics at the time the trade was initiated. Using the options expiration break even points as stops, the point at which the solid red line crosses the 0 point, a potential risk/reward in excess of 1:7 is possible.

Over the next two days of market action, the decrease in price came to fruition. At market close Wednesday I removed half of the trade and captured a return of 32.6% on invested capital. By end of day Friday I had closed out the other half of the trade, earning 40% on my invested capital. My cumulative return on the butterfly put spread was around 38% on total capital risked.

When considering the dynamic nature of option positions, one of the fastest potential movers is a butterfly at expiration. As the position approaches expiration, the rapid decay of time premium results in extreme sensitivity to price movement. Butterflies turn from gentle creatures lazily flapping their wings in the breeze to man eating dragons as expiration approaches. Be prepared to slay the dragon before he can take your hard earned profits.

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