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The price of a time spread fluctuates with movements in stock price. A time spread is at its widest when the stock price and the strike price of the spread are identical or at-the-money.

As the stock moves away from the strike in either direction, the value of the time spread decreases. As the stock moves in either direction from the spread’s strike, the closer month will experience a quicker price change due to the front month’s higher gamma.

Gamma shows the rate of change of an option’s Delta in relation to movements in the price of the stock. It is the Delta of the Delta! Gamma is highest in at-the-money options and in the front month. It decreases as you move away from the at-the-money strike and as you move out over time.

In the same way that a time spread loses value as the stock price moves away from the strike price, the opposite holds true. As the stock price moves closer to the strike price, the value of the time spread increases.

Examine the June / July 65 call time spread. With the stock priced at $65, directly at the strike, the spread is at its widest point or highest value. As the stock climbs from $65 and pushes toward $70, the June / July 65 spread loses value.

At the same time the June / July 65 loses value, the June / July 70 spread gains in value as the stock approaches the 70 strike. When the stock reaches $67.50 the point equidistant (mid-point) between the two strikes, both spreads will trade at approximately the same value.

Look at Chart 2. Notice that as the stock increases from $57.50, both the June / July 65 and June / July 70 spreads increase in value. Their increases continue until they reach their strike price at which time they both begin to lose value.

This demonstrates that the spread with the strike price that the stock is moving toward will increase in value. Meanwhile, the spread with the strike price that the stock is moving away from will simultaneously lose value.

Chart 2 follows the effect of the movement of the stock price across the two time spreads.

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The best way to see how anything works is to break it down into smaller components. From there, it is much easier to understand how each contributes to the overall arrangement. In the case of option strategies, we want to break positions that are more complex down into synthetic positions to get a different perspective.

Just about everything can be broken down synthetically and the Butterfly is no exception. New traders are often overwhelmed by looking at the about the Butterfly with, “I’m long this option, I’m long two of these, I’m long this other one, and there are three different strikes and four options…” It is not overwhelming and definitely not that complicated if you step back and look at it synthetically. In the chart below, the left side shows the construction of a long May 55 Butterfly:

We can break this complicated looking structure down in just one simple step. Rather than view the long Butterfly as long one 50 call, short two 55 calls, and long one 60 call as we have done on the left, let’s pair them in a different way. Instead, pair the long 50 call with one of the short 55 calls. Then let’s pair the other short 55 call with the long 60 call as we’ve done on the right side of the diagram – and look what we have.

First, look at just the blue. We are long one May 50 call (+1), and short one May 55 call (-1). This is simply a long vertical call spread or, more specifically, a bull call spread. Now move a little further off to the right and look at the red numbers. We are short one May 55 call (-1) and long one May 60 call (+1). This is a short vertical call spread, or a bear call spread.

When you break down the long Butterfly on the left, you end up with two vertical call spreads that are converging against each other. In other words, the Butterfly is nothing more than a bull spread and a bear spread acting together. The May 50-55 call spread, represented by the blue, maximizes its profits if the stock rises to 55 or higher.

We know it maxes out at 55. Anything above 55 is just extra security. That is our ability to sleep at night. Meanwhile, our short May 55- 60 call spread to the right represented in red maximizes its profits if the stock falls to 55 or below. So if the bull spread maximizes at 55 or higher and the bear spread maximizes at 55 or lower then a stock price of 55 will maximize both spreads.

Both of these converging spreads want the stock to go to the Butterfly’s middle strike, and that is exactly what you want to happen when you are in a long Butterfly. You want that stock price to finish directly at the middle strike - in this case, the 55 strike. That is your goal, because if it does, your vertical call spread maxes out on a positive side and your short vertical call spread also maxes out on the negative side. Fifty-five is where you want this position to close.

We stated earlier that most butterflies are initially set up with the short “center” strikes at-the-money. Once again, the reason is because it is a premium collection strategy and we want to be short at-the-money options since that is where the biggest extrinsic value is. Too many people forget that the Butterfly is a premium collection strategy. We are not looking for big stock movement. We are looking for stagnation. We are going to use our two short at-the-money options that are rich with decay. They have big extrinsic value, and we want to collect that extrinsic value. We capitalize on this by shoring two of them.
Now remember, the difference with the Butterfly is that it is a premium collection strategy that has a hedge. The hedge derives from the outer strikes, or the 50 call and the 60 call in this example. We know from a reward standpoint that vertical spreads provide a limited reward for both the buyer and the seller. In addition, from a risk standpoint, the buyer and the seller have limited risk.

Let’s look first at our left side – the blue side – the long 50-55 call spread. If you own the 50 call and sold the 55 call, what is the worst that can happen? Think back to your basic rights and obligations with options. You have the right to buy stock for 50 and the obligation to sell it for 55, which means the most the spread will ever be worth is the difference in strikes, or five dollars in this example, if the stock rises to 55 or higher. Therefore, if the stock is at 55, that is great; we maxed out the spread.

If the stock trades down to 50, we are going to lose everything. But – and it is a big but – we are not going to lose any more than what we spent. That is the risk scenario of a vertical call spread: you can only lose what you spent to enter the vertical spread so it is a limited risk strategy.
Therefore, for our Butterfly, if the stock started trading down, our risk is limited to 50. If the stock continues to fall below 50, it does not matter since our risk is fixed at 50.

Look at the other half of the Butterfly - the short 55-60 call spread. If we are short the 55 call and long the 60 call then we have the right to buy stock for 60 and the obligation to sell it for 55, which results in a five-dollar loss if the stock is 60 or higher at expiration. We obviously want the stock to close at 55 or below.

As a seller, we have maxed out our spread and our profit in the spread. Remember, if the stock were to run up above 60, our loss is limited in that spread because the vertical spread has a limited loss scenario for both the buyer and the seller.

The Butterfly therefore consists of two conflicting spreads. One spread wants the stock to move higher while the other wants it to move lower. Both spreads ideally want the stock to move to, or better yet, if we put it on properly, stay at 55. Moreover, if by chance the stock moves in either direction against this, we have a limited loss scenario. There is your premium collection and your hedge.

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The Butterfly’s primary objective is premium collection. The Butterfly is a premium collection strategy (much like the Straddle and Strangle) except for a significant difference. The difference is that the Butterfly is a hedged premium collection strategy.

That is what separates it from most of the other premium collection strategies.

Because the Butterfly is a hedged premium collection strategy, it has a fixed loss profile and is not as aggressive or risky of a premium collection strategy like the Straddle or the Strangle. However, as with any investment, if you take less risk you must get less reward.

The Butterfly’s primary goal is premium collection, which comes through the sale of the center strike options. However, in order to hedge, you must somewhere and somehow give up a little something. That something is going to be a portion of the total potential premium collected. In other words, we will use a portion of the premium we collect from selling the center strikes to buy the outer strikes. These outer strikes protect us from losses at the expense of reducing our potential profit.

The Butterfly is not going to be as big of a moneymaker as a Straddle or Strangle, but it will not expose you to as much loss. The following charts show the profit and loss profile for the long Butterfly:

For any profit and loss diagram, the “bends” in the chart always occur at a strike price. For the long Butterfly, points A and C represent the long strikes.

Point B is the short position located at the center strike. By looking at the profit and loss diagram for the long Butterfly, you can see that the trader wants the stock price to stay still at the center strike (point B) since that is the point of maximum profit. As the stock moves to the right or left from the center peak, profits reduce until the position breaks even. If the stock price moves beyond the break-evens, the ensuing loss will only last for a little while before the graph flattens out at strikes A and C and the red line heads sideways.

That is why the arrows point sideways. Now you can clearly see the reason for buying the outer strikes A and C; they hedge us against unlimited losses. This means that once the stock price moves beyond a certain point either up or down, your losses stop accruing. Any further stock price movement in that direction will incur no further dollar loss.

Now let’s take a look at the profit and loss diagram for the short Butterfly:

This profit and loss diagram tells a different story. While the long Butterfly trader wants the stock to stay at the center strike, the short Butterfly trader wants the stock price to move far away from the center strike. This should make intuitive sense because we said earlier that the short Butterfly trader is simply taking the opposite side of the long Butterfly trader. This means that the profits to the long Butterfly trader are exactly the losses to the short Butterfly trader and vice versa.

We know to classify the Butterfly as a premium collection strategy with risk protection. We know how the Butterfly is constructed. It is either all calls or all puts with three equidistant strikes in a 1-2-1 format. Now let’s dive deeper and see how it works.

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I am sure many of you have heard of a sophisticated sounding strategy called the Butterfly. For some reason, it seems to be the darling strategy of many of those “teach-you in five hours” type option companies. They publicize the “mystical magical Butterfly” and the “sophisticated Condor” as if they were going to unlock the options version of Pandora’s box. I guess they feel that, by introducing you to the catchy named strategies, they will grab your attention and thereby give them a chance to promote themselves. From a marketing standpoint, that is not a bad idea.

However, the Butterfly is a “sophisticated” only for those that do not know options! If you have done your homework and have learned the option basics properly, then the Butterfly is a simple strategy that is just a combination of an already familiar, basic strategy. Let’s take a closer look and uncover the secrets of the mysterious Butterfly!

Butterfly Construction

The first thing you must understand about the Butterfly is that it is constructed by using either all calls or all puts. The Butterfly is never a combination of the two. (We will talk about an exception called the Iron Butterfly later.)

Whether you choose to use calls or puts, butterflies are always constructed in a “1-2-1” arrangement. For the long Butterfly, you would buy one low strike, sell two medium strikes and buy one high strike with the strike prices equally spaced. The center strike typically matches the current price of the stock.

For example, if the stock is 55 and you decide to create a long Butterfly by using calls, you could buy a 50 call, sell two 55 calls, and buy one 60 call. If you decided to use puts, you could buy a 50 put, sell two 55 puts, and buy one 60 put. The long Butterfly is always long the outer strikes and short the center strike.

You would construct the short Butterfly in the opposite way. The short Butterfly will always be short the outer strikes and long the center strike. For example, to create a short Butterfly, you could sell a 50 call, buy two 55 calls, and sell one 60 call. The short Butterfly trader is simply taking the opposite side of the trade with the long Butterfly trader.

This is not a complicated construction. The trick is to understand that while there are three strikes to a Butterfly, there are four options involved. I know the construction will be hard to associate with long or short in the beginning, so here is a little trick or two to help you remember how to differentiate a long Butterfly from a short Butterfly.
When I think of whether a Butterfly is long or short, I always look at that first strike. If that first strike is long, then it is a long Butterfly. It is as simple as that. Some people find it easier to just focus on the center strike where you have the two-option position. If you are short the center strike, then you are long the Butterfly.

The opposite would be true for short butterflies. These are just a couple of ways that you can determine whether a Butterfly is long or short until you become so familiar that you automatically know which Butterfly is which. Until you get to that point, you will want to use little tricks to remember which one is which. Use whichever is most comfortable but I suggest you focus on only one “trick” and use only it until you become so familiar with butterflies you don’t need it any longer to recognize which one you have. Make your choice and stick with it!

The following chart shows the long and short Butterfly construction:

Notice that the strike prices are equally spaced. This is a necessary aspect of all butterflies. However, while the strikes must be equally spaced, they do not need to be spaced by five dollars as in this example.

We could have spaced them by ten dollars and created a different long Butterfly by purchasing the 45 call, selling two 55 calls, and buying one 65 call. You just have to understand that the strikes must be set up in an equidistant manner and they must be either all calls or all puts in the proper 1-2-1 ratio.

From a terminology standpoint, we call this the 50/55/60 Butterfly or, more simply, the 55 Butterfly taking the lead from the Butterfly’s middle strike.

We add to that term whatever month you are dealing with. If we are referring to the June expiration cycle, it would be called the June 55 Butterfly. If we were in April, it would be called the April 55 Butterfly.

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Since the Strangles’ profit potential is dependent on its price from purchase time to expiration, the investor should be aware of the several factors that affect the Strangles’ price.

Stock Price

The first is, of course, stock price. The stock’s price will dictate the value of both components of the Strangle – the call and put thus affecting the Strangle price as a whole. As the stock price moves, the prices of the call and the put will fluctuate via the current Deltas of the options and thereby affect the price of the Strangle.

As the stock moves higher, the price of the call will increase while the price of the put will decrease. However, they do not move linearly meaning that as the stock continues higher, the call’s value increases progressively more while the put’s value decreases progressively less. The option’s changing Delta causes this non-linear effect.

The call Delta increases as the stock goes up while the put Delta decreases as the stock goes up. This opposing effect continues until finally the call gains value dollar for dollar with the stock (once its Delta reaches 100) indefinitely. At the same time, the put value-loss stops because the put now has no value (as put Delta approaches 0). Of course, the opposite is true if the stock trades down.

The call will lose value progressively slower until it reaches $0 while the put will gain value at an increasing rate until the Delta becomes 100 and then the put will gain dollar for dollar with the stock indefinitely. The effect of stock movement on the dollar value and Delta value of the Strangle is in the chart below.

Again, we will use the July 60/65 Strangle as an example. The Strangle will be worth $3.31 ($2.11 for the call, $1.20 for the put). For clarification, these prices are not expiration prices. This Strangle has three weeks to go before expiration.

Implied Volatility

A second factor that affects the pricing of a Strangle is implied volatility. As implied volatility increases, the value of the Strangle increases. As stated, the price of both calls and puts increase as implied volatility increases.

A Strangle will feel an increased effect when volatility increases because the strategy employs two options working together and not against each other. When a strategy uses two options working against each other, the effect of implied volatility on the strategy is the difference of its effect on each option. This is different from a Strangle. With a Strangle, the two options are working together combining the effect of implied volatility on each option.

Implied volatility movement affects an individual option to an exact dollar amount as indicated by the option’s volatility sensitivity component or Vega. An option with a $.05 Vega will increase five cents in value for every tick that implied volatility increases and likewise will decrease in value five cents for every tick that implied volatility decreases.
Because the Strangle combines a call and a put, the Vega value of the call adds to the Vega value of the put. This means that the Vega of a Straddle is the sum of the Vega of the call plus the Vega of the put.

Look back at our example. If the July 65 call has a .10 Vega and the July 60 put has a .07 Vega then the July 60/65 Strangle will have a .17 Vega. This means that for every tick that implied volatility increases, the July 60/65 Strangle will increase $.15 in value.

Conversely, for every tick that volatility decreases, the July 60/65 Strangle will decrease in value. The chart below shows how the Strangles’ value changes at different implied volatility levels.

When you study the chart, you can see that as implied volatility increases or decreases the value of the Strangle increases or decreases by the amount of the Strangles’ Vega multiplied by the amount of tick change in implied volatility.

Time

Finally, time is another major factor affecting the price of a Strangle. As you have learned from our previous strategies, time takes a toll on all options. Its effect is even more pronounced on this strategy that combines two options for the same time period.

A Strangle will see a much higher rate of decay than a single option. From previous discussions, we should be familiar with the option decay chart and its non-linear curve. As time goes by, the Strangle will decay, day after day, at an ever-increasing rate until expiration Friday at 4:00 p.m. The implication to the buyer and seller should be obvious.

The passage of time decreases the value of the Strangle and thus always favors the seller. Time works against the buyer. The buyer has only until expiration to get either a large stock or implied volatility movement to offset the price paid for the Strangle.

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The Strangle is a strategy that relies on movements in stock price or implied volatility to establish profit opportunities. The Strangle buyer looks for the stock to move aggressively in either direction or for the anticipated perception of possible aggressive moves that brings about an increase in implied volatility.

Sellers of the Strangle hope for the opposite, of course. A lack of stock movement or a perceived lack of movement causing implied volatility to decrease creates profitable scenarios for the Strangle seller.

Strangle Mechanics

Look at the July 60/65 Strangle in our illustration. We can either buy or sell the Strangle. If we purchase both the July 65 call and the July 60 put simultaneously in a one to one ratio, we have a long Strangle. We would sell both the July 65 call and July 60 put simultaneously in a one to one ratio to construct a short Strangle.

Continuing with our illustration, we will set the price for each of the options. With our imaginary stock trading at $63.50, the July 65 call trades at $2.11 and the July 60 put trades at $1.20. The combination of these two prices accounts for the $3.31 cost of the Strangle.

Fast forward to expiration and observe what happens to the value of the Strangle at different stock prices at expiration.

As you can see, the Strangle’s value increases the further the stock moves below the lower strike or above the upper strike. The closer the stock is to the area defined by the inner border between the two strikes, the lower the value of the Strangle at expiration. The chart clearly shows that the more the stock moves away from the inside of the strikes, the higher the Strangles’ value becomes.

Conversely, the closer the stock finishes to the area in between the strikes, the lower the value of the Straddle. Owners of Straddles want and need movement while sellers of Straddles want and need stagnation.

How does this example influence your investment strategy? If you feel a stock is likely to move aggressively in either direction or if you expect implied volatility to increase, possibly due to impending news (such as earnings, FDA approval, etc.), you should look into the purchase of a Strangle.

However, if you feel that a stock is likely to enter a stagnant phase or if you feel that implied volatility is likely to decrease, then the sale of a Strangle could be a very profitable trade for you.

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The Strangle is another option strategy that features the use of options in unison with each other. The Strangle is philosophically identical to its “cousin” the Straddle. However, whereas the Straddle has a single strike as its focal point, the Strangle has its focal point spread out over two strikes.

The effect of this as compared to the Straddle is that the Strangle will produce wider break-even points and lower prices. The widening of the break-even points changes the risk/reward scenarios for both the buyer and the seller of the Strangle as opposed to the Straddle.

The benefit to the buyer of the Strangle is that it will cost less than a Straddle (thus less risk) but, like all risk/reward scenarios, less risk equals less reward. The buyer’s trade-off for lower cost and less risk is that the stock will have to move significantly more than if the buyer had purchased a Straddle.

The benefit to the seller of the Strangle is that it offers a larger margin of error in terms of the anticipated stock movement. The wider range of the break-even prices allows the stock to have more movement while still allowing the seller to profit. The seller’s trade-off for this luxury is price. The seller will not bring in as much premium from the sale of a Strangle as opposed to the sale of a Straddle.

With that said, let’s look at the Strangle. The Strangle, like the Straddle, consists of two options. In the Strangle, however, the two options are not at-the-money options of the same strike (Straddle), but out-of-the-money options (both a call and a put) of different strikes.

The Strangle features one position (either long or short) and two options: an out-of-the-money call and an out-of-the-money put.

When you put together a Strangle the construction should be as follows:

• Different options (out-of-the-money call & an out-of-the-money put)
• Same stock
• Same expiration
• One to one ratio

Strangle positions are referred to as “long Strangle” or “short Strangle” depending on whether you purchase the call and the put (long) or sell the call and the put (short).
For example, with the stock trading at $57.50, you would construct the long Strangle by purchasing both the July 60 call and the July 55 put. You would construct the short Strangle by selling both the July 60 call and the July 55 put.

It is important to note that the Strangle is a one to one ratio strategy. For every call that you buy (or sell), you must purchase (or sell) exactly one put to properly construct a Strangle. Below, find a chart showing the proper Strangle constructions.

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After two weeks of holiday interrupted, low volume trading, the US equities markets got back on a regular schedule yesterday and it looks as though the weakness could be with us for some time for fundamental, technical, and geo-political reasons. With the dollar at historic lows, energy at historic highs, top lending institutions denying rumors of bankruptcy, and the always uncertain status of US diplomatic relations in oil producing areas, it would be very difficult for even the most steadfast contrarian to engage in a bullish argument here. One caveat that I will add to that statement, however, is that the largest positive price movement days usually occur during primary downtrends so don’t be surprised to see a day where the INDU adds 400 and the COMPX gains 100.

But the general gloomy scenario continues to loom, and it is difficult to avoid reference to the dirty word of “stagflation” especially since it recently was on the omniscient lips of former Federal Reserve Chairman Greenspan. Crude oil briefly touched $100 per barrel twice last week before retreating to slightly over $95 per barrel yesterday, which is, depending on calculation method, just about on par with inflation adjusted all time highs of the early 1980’s. Add to that the compounding data that is pointing directly at an economic contraction cycle, and it would seem that additional downside is waiting in the wings, regardless of the smoke and mirrors that is being used to manipulate the global liquidity situation.

Of course anyone who is an Options University/Options University Strategist student or subscriber would have been prepared for this downside by being properly hedged and completely expectant of the movement that we have seen. But the beat goes on, and last week was a very interesting one as it pertained to the manner in which the markets digested macroeconomic data. For quite some time, recessionary data had been construed by the markets as buying stimulus, simply for the fact that it would undoubtedly cause the FOMC to ease monetary policy and therefore prop up the markets, artificially in my opinion. However, beginning with two events last week, the ISM index on Wednesday, and the employment report on Friday, that paradigm has begun to change. Both numbers came in below market expectations quite significantly to add to the recessionary case. However, after each report, instead of rallying in hopes of further cuts, the markets tanked quite drastically. And with the fed fund futures seemingly pricing in another 50 bp cut at the Jan 29 meeting, the subtle recessionary news released by AT&T and CFC today, resulted in a nearly 300 pt. tailspin in the INDU.

Technically, all three major indices have closed below the November lows, and the SPX closed today below its 500 day simple moving average. Moreover, after finding obvious, although temporary, support at several Fibonacci retracement levels from the March low to the October high, the only level left is the 100% for the SPX and that would bring us to 1364. As foretold by the staff at OU, the VIX reverted to its mean from the December 24 low, coincidentally at the 200 day sma, to add almost 38% in two weeks. There are a lot of ways to make money in these markets, but only if you are educated enough to take advantage of the opportunities.

Gregory Wolfe
The Options University

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Source: Quote.com®

NOTES ON RED HAT INC. (RHAT)
Short Straddle

1. After running up from the 6-8 dollar range, RHAT put in a high of about $28 before breaking down to a lower trading range in the $15 area.

2. Once falling into the new trading range in early July RHAT starts to develop a new range around $15. The range starts out relatively wide but appears to tighten as time goes on. This consolidation is an ideal time to sell a strangle.

3. The short strangle involves the simultaneous selling of an out-of-the-money call and an out-of-the-money put. For this, you will have a position that collects money as time passes. The short call and short put will provide break-even prices above the call strike and below the put strike. If the stock stays between these two break-evens between now and expiration, you will collect the value of your short strangle.

4. As the stock continues to consolidate and the range tightens, there is a chance that a short straddle will be better in the future the stock’s range tightens.

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Source: Quote.com®

NOTES ON PRIDE INTERNATIONAL (PDE)
Short Straddle

1. Pride Int’l breaks out of a trading range in Jan 2005 and proceeds to trade up around the $27 level. After trading back down to around $20 (in a style that would also be perfect for a sell-write) the stock trades back up to the $25 range.

2. At this price, Pride begins to consolidate in this $25 area. This consolidation begins around min-June and extends through August and into September. This consolidation around the $25 stock price presents an excellent opportunity for premium collection via the short straddle.

3. By selling both the 25 strike call and put, which are both at-the-money options, you will have the opportunity to capture a large amount of premium.

4. The straddle will set up breakevens both above and below the strike for proceeds brought in by the sale of the straddle. If the stock closes near the 25 strike at expiration, the stock will more than likely finish inside of the breakeven parameters profiting the straddle seller.

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