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BUTTERFLIES ARE BEAUTIFUL

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While we're waiting for time decay to do its thing on our September and October positions, I thought it a good time to review one of the more popular and versatile non-directional strategies - the Butterfly.

I wrote this article earlier this week for publication in my book, so the prices used in the example are dated. At the end of today's column, I'll explore some September Butterfly possibilities based on Friday's closing prices. If you are a strategy column saver, you might want to print this out for further study and/or review before it disappears into the abyss of the OptionInvestor archives.

The Butterfly Strategy

Another popular income generating strategy is the Butterfly spread. There are many interesting uses for the Butterfly. Let's start out by examining the most common version - the ATM (at-the-money) Butterfly.

One of the most appealing aspects of the Butterfly trade, is the risk-reward ratio. The Butterfly is a debit spread and typically costs very little. The reward, however, can be substantial.

We're used to trading credit spreads (Iron Condors) in which we may risk $940 to make $60. On the surface, that sounds outrageous - even borderline insanity. What makes the credit spreads worthwhile is the high (90-95%) probability of success of the positions we select.

The Butterfly, is also a non-directional strategy. It's best done in a stagnant market, 30-45 days prior to expiration. The shorter the time frame, the better. Why? Because we make our money from time decay.

The Butterfly consists of one long call, the sale of two short calls and the purchase of another long call - all the same expiration month with both long calls being equidistant from the two short calls in the center. Sounds complicated, but it isn't really.

Butterfly spreads can also be done using puts. You can choose whether you want to use the puts or the calls by calculating the costs of each. Then, simply use the one that costs you the least. For our example, we will use call options.

The best way to learn about the structure of a Butterfly is by looking at an example. At this writing, the XSP (tracks the S&P 500) is at 123.00. There are 38 days until October expiration.

Buy 1 October XSP 121 call @ $5.10

Sell 2 October XSP 123 (ATM) call @ 3.80 = 7.60

Buy 1 October XSP 125 call @ $2.88

We spent $7.98 purchasing the 121 and 125 calls ($5.10 + $2.88). We brought in $7.60 by selling two of the 123 calls. The result is a debit of $.38. That is $38 per contract ($7.98 - $7.60).

The total risk on the trade is the $.38 debit. The maximum profit is achieved, at expiration, if the XSP closes at 123. Should that happen, your profit will be $2.00 less the original $.38 debit resulting in a net profit of $1.62. That's a return of 426% on the risk.

What are the chances of the XSP finishing right at 123? Don't hold your breath. I have a better chance of waking up between Jessica Alba and Angelina Jolie with a fond memory.

The realistic objective trading the Butterfly spread is not to win the lottery. It's part of a program to achieve a monthly cashflow. We want to make a nice percentage return on our risk.

Calculating the results, at expiration, of the Butterfly trade is not difficult, once you grasp the concept. Let's take a look at a few scenarios and do some math.

If the XSP settled at 121.65, here are the values:

1 XSP 121 long call would be worth $.65

2 XSP 123 short calls would expire worthless

1 XPS 125 long call would expire worthless

We have a net of $.65. The initial debit was $.38. The profit is $.27.

If the XSP settled at 123.88, here are the values:

1 XSP 121 long call would be worth $2.88

2 XSP 123 short calls would $.88 x 2 = ($1.76)

1 XPS 125 long call would expire worthless

We have a net of $1.12. The initial debit was $.38. The profit is $.74.

If the XSP settled at 126.10, here are the values:

1 XSP 121 long call would be worth $5.10

2 XSP 123 short calls would $3.10 x 2 = ($6.20)

1 XPS 125 long call would be worth $1.10

We have a net value of zero. The initial debit was $.38. The loss is $.38.

If the XSP settled at 122.86, here are the values:

1 XSP 121 long call would be worth $1.86

2 XSP 123 short calls would expire worthless

1 XPS 125 long call would expire worthless

We have a net of $1.86. The initial debit was $.38. The profit is $1.48.

That should give you a pretty good idea of what to look for when placing an at-the-money condor. The further out you buy the long options, the more expensive your Butterfly will be. However, your potential profit increases and your breakeven prices are better. The closer you buy the long options to the short strike, the less expensive your Butterfly spread will be.

Using Butterflies For Hedging

The fact that the Butterflies are inexpensive gives us some additional flexibility in how we use them. For relatively little, we can use the Butterfly to hedge other positions.

For example, if we have an Iron Condor, and one of the credit spreads is being threatened (20 points away), you might consider dropping a Butterfly above or below the short strike price of the credit spread. My friend, options expert Dan Sheridan, calls these speculative "Time Bombs."

If the SPX (S&P 500) is trading at 1225 and you have the 1205/1195 as the bull put spread of your Iron Condor, you could place a Butterfly just below the 1205 short strike prices.

Above we looked at the ATM Butterfly. However, the further you are out-of-the-money with your short strikes of your Butterfly, the less it costs to put on the Butterfly. Check this out.

Buy 1 SPX 1195 call @ $7.90

Sell 2 SPX 1185 (ATM) call @ 6.20 x 2 = 12.40

Buy 1 SPX 1175 call @ $4.70

Net debit is only $.20 ($12.60 - $12.40)

If the SPX blows through your spread and settles near 1185, you could make back a chunk of what it cost you to close the credit spread.

You can also use these out-of-the-money Butterfly spreads during expiration week (or before) for inexpensive speculation. For $20 ($.20 x 100) per contract, you could drop these little Time Bombs all over. If the index settles near your short strike, you might have a big smile on your face all the way to the bank.

Placing The Butterfly Trade

One of the drawbacks of the Butterfly trade is that it is commission intensive. There are four commissions going in and another four coming out - assuming you close the position early to lock in profits (like you?re supposed to do). That's why it's important to have a good broker.

The best way to place a Butterfly trade is as a single trade with a net debit. The good options brokers will, on their trading platform, have a page specifically for Butterfly trades. You will input the appropriate symbols and quantities and enter the net debit ($.38 in the above example). If you're not with a progressive options broker, you aren't taking your trading seriously and you might as well close this book and go to Las Vegas.


We go over the Butterfly sreads, and other variations, in depth at my two-day seminars. There are still spots left for Dallas and Orlando. If profits matter to you, why go through the trading deserts and not know how to avoid the land mines? If you don't want to step on it or step in it, come join us.

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Butterfly Idea
As an exercise, let's take what you learned (hopefully) above and create a Butterfly position using Friday's closing prices. In the article above we used the SPX and XSP as examples. So, for a change of pace, let's use the RUT or IWM as our underlying and look at making money in the remaining week of the September cycle.

With the RUT trading at 720.26, the IWM (which tracks the RUT) is at 72.25. Let's first look at an ATM Butterfly.

Buy 1 IWM September 71 put @ $.77

Sell 2 IWM September 72 (ATM) puts @ 1.12 x 2 = 2.24

Buy 1 IWM September 73 put @ 1.63

Net debit is $.16 ($2.40 - $2.24)

The risk is only $16.00/contract (.16 x 100).

For a 10 contract position, the risk is only $160 and the possible reward is $840.

Now, let's put one of those Butterfly "Time Bombs" a little OTM.

Buy 1 IWM September 69 put @ .32

Sell 2 IWM September 70 (ATM) puts @ .50 x 2 = 1.00

Buy 1 IWM September 71 put @ .77

Net debit is $.16 ($2.40 - $2.24)

The risk is only $9.00/contract (.09 x 100).

For a 10 contract position, the risk is only $90 and the possible reward is $910

See how inexpensive these Butterflies can be? You could drop them above and/or below the RUT and, if the markets cooperate, you could hit it big. The commissions might eat away at the profits a bit, but the profit is out there - IF you put the ?Time Bombs? in the right places.

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CPTI SEPTEMBER Position #1 - RUT Bull Put Spread - 720.26

On 7/31, with the RUT at about 720, we sold 20 RUT September 610 puts and bought 20 RUT September 600 puts for a credit of $.55 ($1,100). Maintenance is $20,000.

CPTI SEPTEMBER Position #2 - SPX Bull Put Spread - 1251.70

On 8/7, with the SPX at about 1275, we sold 20 SPX September 1120 puts and bought 20 SPX September 1110 puts for a credit of $.55 ($1,100). Maintenance is $20,000.

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CPTI OCTOBER Position #1 - RUT Bull Put Spread - 720.26

On 8/18, with the RUT at about 732, we sold 20 RUT October 600 puts and bought 20 RUT October 590 puts for a credit of $.55 ($1,100). Maintenance is $20,000. I'll look to put on a bear call spread in the future - IF it makes sense.

CPTI OCTOBER Position #2 - SPX Bull Put Spread - 1251.70

On 8/25, with the SPX at about 1267, we sold 20 SPX October 1110 puts and bought 20 SPX October 1100 puts for a credit of $.60 ($1,200). Maintenance is $20,000. I'll look to put on a bear call spread in the future - IF it makes sense.

CPTI OCTOBER Position #3 - SPX Bear Call Spread ? 1251.70

On 9/2 with the SPX at about 1294, we sold 10 October 1415 calls and bought 10 SPX October 1425 calls for a credit of $.55 ($550). No additional maintenance is required since we already have the SPX October bull put spreads.

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ONGOING STRATEGY - THE ZERO-PLUS Strategy
In the past, I outlined a strategy based on an initial investment of $100,000. At that time, $74,000 was spent on zero coupon bonds maturing in about seven years at a value of $100,000. The principal $100,000 investment is guaranteed. We're trading the remaining $26,000 to generate a "risk free" return on the original investment. We are not compounding our profits by dramatically increasing the number of contracts we trade. With the July profits, our new cash total is $64,220 ($62,110 + $2,100).

SEPTEMBER ZERO PLUS POSITION - 720.26

On Friday 7/25, I put out an order to sell 30 September 1080/1070 bull put spreads for $.70. It was filled when the SPX dipped to 1251. That's $2,100 of premium. It's going to be a long wait, but I'm in no hurry.

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SHORT & SWEET - RUT - 720.26

On 8/1, we opened a new hypothetical "Short & Sweet" position, selling 4 December RUT 560 puts and selling 4 RUT 850 calls for a total credit of $11.60.

Traders with less experience, smaller trading accounts or those without customer portfolio margining, might want to buy 4 of the September 570 puts and 4 of the September 850 calls to give you two months (August & September) where the short positions are covered for about $1.10. Their net credit would then be $10.50.

Our objective is to do exactly what we did with the previous Short & Sweet Strangle. We want to let time decay and reducing implied volatility do their thing, so we can close the position and lock in some nice profits.

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Couch Potato Trader Disclaimer
All results reported in this section are hypothetical. While the numbers represented here may have been achieved or beaten by our readers, we make no representation that any individual investor achieved these exact results. The tracking for the plays listed in this section uses closing prices for the day the newsletter is published and it is not meant to imply that any reader actually received those prices (though many often do) or participated in these recommendations (even though many do). The portfolio represented here is hypothetical and for investment education purposes only. It is only an illustration of what type of gains a knowledgeable trader might receive utilizing these strategies. If you don't get close to these results, guess what. It isn't the fault of the strategies.

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