Quick, can you say whether a calendar bought at the money or out of the money would be cheaper? What about a butterfly?

Let's take a look. I'm going to be using end-of-day values. That's usually not a good idea, since spreads tend to widen and some strange things can happen with volatilities. However, for the purpose of comparing these ATM and OTM prices, they'll be suitable.

For those of you who are new to trading complex options strategies, a calendar is trade in which a nearer-month option (either put or call) is sold and a further-out option of the same strike and type is bought. For example, I might have a calendar in which I've sold an SPX JUL 1080 call and bought an SPX AUG 1080 call. I would pay a debit to enter the trade, and that debit would be my total risk. There's one caveat to that statement, however. That's in the case in which I've sold a call in an underlying that has dividends, and that call is in the money with little time value left when the ex-dividend day comes and goes. My sold call could be called away, and I could owe someone dividends in addition to being short the stock. Ordinarily, being short the stock is not a huge problem because I could then exercise my long AUG call, but then I would lose all the time value left in that trade. This isn't something that happens often, but it's a remote possibility that no one ever lists when they say that the most you can lose in a calendar is the debit you paid to enter it. You can also lose dividends and extra transaction costs, although it's rare to do so.

A traditional butterfly is formed of all calls or all puts, and is formed by selling calls or puts to form the body, and then buying a long option position above the sold options and a long option position equidistant below to form the wings. The number of options sold is two times the number of options bought for each wing. For example, I could form an OEX butterfly by selling two AUG 500 puts and then buying 1 AUG 525 put and 1 AUG 475 put. Other types of butterflies exist, including the iron butterfly, split-strike butterfly, and broken-wing butterfly, but we're considering the traditional butterfly in this article.

With the SPX at 1117.51 at the close of trading on June 18, I priced several calendars.

SPX 1115 Call JUL/AUG Calendar: $1,283.00
SPX 1130 Call JUL/AUG Calendar: $1,248.00
SPX 1160 Call JUL/AUG Calendar: $1,068.00

The ATM calendar was the most expensive, with the cost decreasing the further OTM the calendar was. This was also true if the calendar was below the current price as well as above the current price. It was also true of put calendars. Unless there's an aberration in options price, the most expensive calendar will be the ATM calendar.

On the same day, with the OEX closing at 504.70, I priced butterflies with 30-point wings.

OEX 500 Call JUL Butterfly: $2,539.00
OEX 515 Call JUL Butterfly: $1,973.00
OEX 525 Call JUL Butterfly: $ 978.00

As was true with the calendars, the most expensive butterfly is the ATM butterfly, with the butterflies getting progressively cheaper as the central strike moves away from the money. The further out of the money those butterflies are, either to the upside or the downside, the less expensive they are.

The answer should be intuitive if I think about where I would want the price of the underlying to end up at expiration. (I have to add the warning that it's not always a good idea to hold these into expiration week.) The expiration profit/loss chart for both strategies assumes a tent-like shape, with profit at expiration the highest at the location of the sold strike. If the profit is highest at that point at expiration, it stands to reason that the cost of entering that strategy is going to be at its highest right at the sold strike, too.

So, what's the point of this quiz? First, we should have a picture in our minds at all times of the shape of the expiration profit/loss chart and where the current price is positioned within that shape. Has the price moved so that it's now outside the profit zone at expiration? That's a problem calling for an adjustment.

As the price of the underlying moves further and further away from its central strike, we know that it will be worth less and less. If we bought that butterfly when it was ATM and the butterfly starts moving sharply away from that central strike, we know that the trade is losing money.

Knowing how calendar and butterfly pricing works impacts our trade entries, too. Imagine that a trader is trying to work a butterfly trade, getting the cheapest fill possible. If that trader is someone who works fulltime or isn't always available to watch the markets moment by moment for another reason, an order might be entered outside regular market hours. A trader who is trying to get a good fill could place an order below the mid-price of the bid/ask spread for the calendar or butterfly and leave the trade, hoping it fills. That might not always be a good idea.

Because of what we know about calendar and butterfly trades, we understand that such a trade is more likely to be filled if the underlying moves away from the ATM strike. When we're watching a trade, we may welcome a little jit this way and jot that way that allows our butterfly or calendar trades to fill at what we consider an ideal price. However, what if that movement is not a little jit and jot, but a cascade lower or a rush higher? Would we want our calendar or butterfly to fill if such a movement began or would we want to reposition the butterfly order to a new ATM strike? If we're not able to watch the trades, it's sometimes a bit iffy to put in an order to open such a trade at an under-the-market price because such a fill might occur only if the underlying has moved more than we had thought it would.

Why would someone even try for a fill at a price at or below the mid-price anyway? Most of us are accustomed to paying mid price or a little over the mid price to buy options and selling at the mid price or a little under mid price. However, aberrant orders can come in and be filled so quickly that they don't even make a blip on the quote screen, orders that may allow your fill at mid price or better. Usually, however, a fill better than the quoted mid price means that the underlying has moved away from the ATM level, at least momentarily.

Even if we can get the fill at the mid price, is it always a good idea to enter a calendar or butterfly trade at that mid price? Not always. Before you begin even paper trading butterflies or calendars, familiarize yourself with what would constitute a good price for an ATM calendar or butterfly in your preferred vehicle. That price changes according to volatility and time to expiration, along with other parameters. More than a decade ago when I first began trading actively, for some reason now lost to me, I spent days and days writing down prices of the underlying I was trading rather than just watching charts. That practice, however, turned out to be useful, because the act of writing down the prices every few minutes gave me a sense of the ebb and flow of that equity's prices. I'm a visual person and I don't usually need anything more than charts--I thought--but those few days left their mark. Sometimes I think you need to actually write things down.

How does this relate to calendars and butterflies? A trading group recently assigned its participants the task of choosing a vehicle and recording ATM calendar prices over a week's time. By the end of that week, the participants had an idea of what was a cheap price for their vehicle's calendars and what was an expensive price, at least for the then-current time before expiration and for the then-current volatility levels. Traders were able to place orders at the levels at which they wanted to be filled, rather than the quoted prices, as long as they were able to watch the markets and make sure that the fill wasn't coming because of a big move away from the previous ATM strike. Due to what we know about how calendar and butterfly prices change, however, those traders would perhaps need to pull those orders if the underlying moved too far away from the intended ATM strike. When conditions were right for a calendar--when those traders thought that volatility levels were unlikely to collapse--they knew the levels they thought optimum for ATM calendars.

However, some might want to deliberately move a butterfly or calendar away from the money. What are some the reasons? Someone might have bullish or bearish price viewpoint and want to speculate on the possibility that the price might move to that point. That trader might choose a cheap butterfly or calendar as the appropriate vehicle for that speculation. A trader might have a view about what will happen with volatility, too. For example, the trader who believes that prices are likely to climb higher might decide to set a butterfly above the market. Someone who believes that markets are more likely to drop might set a calendar below the markets. I first heard about this tactic several years ago when studying CBOE webinars in which former market maker Sheridan talked about "time bomb butterflies."

Why a butterfly above the market when the price viewpoint is bullish and a calendar below the market when the price viewpoint is bearish? A butterfly is a negative vega trade. That means it benefits when volatilities drop, and volatilities often drop when prices are climbing. Therefore, the above-the-market butterfly would benefit in two ways: by price climbing toward its central strike and by dropping volatilities. A calendar is a positive vega trade. It benefits by climbing volatilities, which typically happens when prices drop. Therefore, if prices did drop as the trader predicted, that OTM calendar trade would benefit by having prices drop toward the central strike and by climbing volatilities.

Of course, that's a far from exhaustive description of the way that traders might speculate with an OTM butterfly or calendar. As with any speculative trade, along with the greater possible gains come greater possible risks. Most people I know don't trade butterflies and calendars as directional trades. A few do, but that turns them into speculative rather than income-type trades.

Knowing that both butterflies and calendars get cheaper the further out of the money they are, some traders do devote part of their speculative monies to trading far OTM butterflies or calendars. I have a couple of warnings about this, however. I don't have much experience trading OTM calendars as speculative trades, but I do have at least a little with far OTM butterflies, and I've heard other traders speak about them, too. If price moves under the tent of the butterfly or calendar, the profit zone, too soon, the trade might not be nearly as profitable as it would have been at expiration, despite what theoretical profit/loss charts may show.

Whether or not we choose to speculate with butterflies and calendars, this information can be useful to us. What does one do if it's not our intention to speculate, but the underlying happens to be between strikes when it's time to place the trade? IBM traders sometimes have this difficulty because of the 5-point strikes on its options. What if one has a slight directional bias for both price and volatility? Can that help make the decision as to whether to place the butterfly or calendar at the nearest strike above or nearest one below the current price of the underling? Knowing where such trades cost the most or least to initiate and will profit the most help traders to make decisions about how to place their trades. They can better decide whether to initiate a butterfly or calendar trade at which strike.

My takeaway for this article was meant to be this: as traders, we should take the time to learn our vehicles and strategies in and out. We can't always avoid entering at a price that turns out to be too expensive, but knowing the optimum price we want for a strategy and a particular underlying helps us avoid doing so. It gives us an edge. We should also know before we enter a strategy how the profit and loss is going to change not only at expiration but over the next day or week, and how volatility might change that result, too. Some brokerages have P/L or risk-analysis charts that allow traders to change the time to expiration or the volatility, exploring how that impacts the trades. Freeware OptionsOracle allows these inputs, too. So does the expensive OptionVue, of course.