Last week, we looked over the shoulders of some of the traders placing butterfly orders on the morning of Thursday, December 26. To remind subscribers what we were viewing, I've again included a partial view of think-or-swim's Butterfly Spread Book from that morning.

RUT Butterfly Spread Book at 10:24 EST, December 26, with RUT at 1167.58:

Newbies who would like a review of the butterfly trade can find a quick explanation at the beginning of last week's article.

Last week, I charted one of the six-contract at-the-money (ATM) orders for the 1190/1170/1150 JAN put butterflies, speculating about the trader's possible intentions. This week, let's talk about some of the other orders.

Someone had placed a day order to sell a February 1120/1170/1220 call butterfly for a credit of $16.25. The "Mark" column shows the mark or mid-price of this butterfly at 15.65, but I know from experience that this column's price doesn't always coincide with the mid-prices I'm seeing at any given time. For example, my check of theoretical prices that day at about that time show that the mid-price of the butterfly in question was nearer $16.05-$16.15. First, let's consider why the butterfly trader might be attempting to sell a February butterfly so long before February's expiration.

The easiest explanation could be that the trader had already made the planned profit or would make the planned profit if the order filled for $16.25. Since the trade still had 57 days until expiration at that point, I wonder if that was the motive, but it certainly could have been. That's the easiest explanation, but are there others?

Let's isolate this trade on an expiration chart and see what we see. Remember that since this is a sell order, it will show a flipped-over tent shape. Also remember that the RUT was at 1167.58 when the original Spread Book picture was snapped.

Expiration Chart of Order to Sell 1 1120/1170/1220 Call Butterfly on December 26:

The dark blue line describing an inverted tent shape is the expiration graph. In this case, I theorize that the trader might be selling a butterfly to close a position, not to open a new one. If that's true, the position won't be held until expiration, but we can still learn something about possible intentions by looking at the Greeks of the trade. Those are shown in the blue-tinted chart below the expiration graph.

As a reminder, delta shows how much the profit-and-loss (PnL) theoretically changes with a price movement in the underlying. Vega shows how much the PnL will theoretically change with a change in implied volatilities.

If I want to change the deltas or vega exposure on my total position but don't want to invest any more capital in the position in order to do so, I sometimes sell one of my butterflies. For example, if price were running to the upside, my total butterfly position would likely be collecting too many negative deltas. If I had already invested the maximum capital I wanted to invest in the position, I might sell one of the now below-the-money butterflies to raise the delta. I could do this as an alternative to buying a call or a call debit spread, which would require spending more money.

Is that a possibility for this trader's order we see in the December 26 spread book? Clearly, with the center strike at 1170 and the RUT just a little below that, the deltas probably aren't out of whack due to the butterflies. This trade would be raising the delta by only 3.40 points, we see from the legend showing the Greeks at the RUT's then-current price. The trader would be raising the negative vega by 99.37 points, however, so it could have been possible that someone who feared that implied volatilities were about to jump might elect to sell one of the butterflies. Either way, at this point, the butterfly wasn't contributing much theta to the trade since selling it was only dropping the theta by 10.81. It wasn't helping the trade benefit that much from time decay.

Do we know for sure whether the trader was selling because the wanted profit had been reached or the total position's Greeks were skewed in a way the trader didn't want? No. It's possible that the trader wanted to reduce exposure. That's possible, but this sell order is not going to make a big difference in the delta or theta of the position. There's not strong evidence of a need to reduce exposure, unless it was exposure to changes in volatility that were feared.

Do we know for sure that this trader was selling to close a position? Could the trader have been selling to open a new position? Perhaps the trader thought that the RUT was on the verge of moving big, either to the upside or downside, and wanted to capitalize on a move above 1204.34 or below 1135.37 by February's expiration? That's possible, although I don't see too many traders employ butterflies for this type of stand-alone trade. There are easier and less commission-intensive trades that capitalize on an expected big price move, such as a straddle, especially in a low-volatility (RVX) environment such as existed on December 26. Again, perhaps if the trader thought implied volatilities were about to explode higher, this positive-vega trade was the vehicle the trader wanted to capture that explosion in implied volatilities, but it's not the most likely vehicle, in my opinion.

Let's look at the next butterfly order and see an instance when a trader really might be trying to reduce exposure. That's with the order for the two contracts of the 1180/1130/1080 butterfly for $13.19 credit. Remember that the RUT was at about 1167.58 when the image from the Spread Book was snapped. These expiration charts, however, were snapped as time progressed and price might be a little off that number, as it was in the chart below.

Order to Sell Two RUT JAN 1180/1130/1080 Put Butterflies:

At the time the Spread Book's image was captured, the RUT's price was 37.58 points above the center of this butterfly, at what would be the expiration breakeven of the long butterfly. If someone held a position with ten of these butterflies, for example, the delta on the position might have grown too negative, even if the trader had hedged the upside with calls or call debit spreads. The trader who wanted to raise the delta but who didn't want to invest more money in a trade going wrong might elect to sell two of those ten butterflies. The delta would be raised by almost 60 points. Vega would be raised, too, but theta, of course, would suffer, since this order involved reducing theta by 19.39. If the RUT's price had kept going to the north, however, the long versions of these butterflies would no longer be contributing profit as time passed.

The trader could be selling these two butterflies with the intentions of moving them higher, a tactic some traders employ when price reaches the expiration breakevens on existing butterfly trades. The trader's maximum planned loss may have been reached, and the trader may have been exiting the trade altogether.

Discussing all these butterfly orders would require too much time, but one proves particularly interesting. With the RUT at 1167.58, why does someone want to buy a FEB 1220/1230/1240 butterfly? That person must have a particularly bullish view of the markets and the RUT in particular. Or, is there another explanation?

Graph of Order to buy a RUT FEB 1220/1230/1240 Call Butterfly:

The order was placed at $0.50 (or $50/butterfly) when the mid-price as $0.375. It's sometimes necessary to pay a bit more when the strikes are all away from the money than it is when a trade is at the money. Also, we don't know how long that order had been sitting out there that day or even if someone had set the order the night before and was letting it work. At the time it was placed, the mid-price might have been at $0.50.

If the order filled at $0.50, the trader paid $180.00 when commissions were included, so that trader's risk was $180.00. That's the trader's maximum risk in the trade. Since the RUT options are European-style options, there's no risk of those sold calls being exercised before expiration, as there might be with individual equity options, for example. However, if the RUT were to end up between 1220.34 and 1999.70 at expiration, this chart tells us that the trade would be profitable. If the RUT settled at 1230, the trader would glean over $2500!

This is most likely a speculative trade, a low-cost one. I remember years ago hearing former market maker Dan Sheridan speak about "time bomb" butterflies on free webinars for CBOE, and this is an example of a time-bomb butterfly. It's possible for traders to find opportunities to employ their lottery-money speculative funds to set up time bomb butterflies both below and above the market. If one should be hit at expiration, these are exciting trades. If not, not much is lost.

These butterflies can also occasionally be used for other purposes, perhaps to prop up a falling profit-and-loss line near the sold strike of an iron condor position, but that's a risky way to hedge a trade. These sometimes don't show profit until very near expiration. If the price barrels toward the sold strike of an iron condor 30 days before expiration, these type of butterflies might not function as hoped. Just to try out that scenario, I ran the time frame up to 30 days before expiration (not shown). If the RUT were at 1230 thirty days before expiration, that time bomb would theoretically show a profit of $96.00 after commissions. I can guarantee that if the sold call of a high-probability iron condor were at 1230 and that iron condor had been initiated when the RUT was at 1167.58, that iron condor would need more help than $96.00 to hedge the loss.

We can't know for certain what any of these traders were thinking or their goals when establishing these orders on December 26. However, by looking over their shoulders, we can gain a sense of how butterflies function and how flexible they are. We might pick up ideas that will help us in our trading. Be sure to thoroughly test those ideas before you employ them, however.

Linda Piazza

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