Sometimes in my articles, I discuss profit/loss charts for options positions. It wasn't until I was checking the Options Industry Council's site and stumbled across this pdf titled "Understanding Profit and Loss Graphs" that it occurred to me that some options traders might appreciate some help interpreting such charts. Experienced options traders using different platforms might enjoy a peek at such pages from a couple of online trading platforms. In recent articles, I've also included such pages from freeware site Options Oracle, and those previous articles can be viewed for comparisons.

For example, I often talk about butterflies, an options strategy formed by selling options in a multiple of two to form the body, and then buying half that number of contracts above that strike to form one wing and half that number below that strike to form the other wing. For newbies who find my definition convoluted, you'll find an example set up in the chart below. Butterflies can be all-call, all-put or a combination of call and put butterflies. For example, if I had wanted to construct a butterfly on IBM when IBM was recently at 183.35, I might sell 2 IBM 185 puts and buy one 175 put and another 195 one, each of those long puts the same distance away from the central 185 strikes. For clarification, I chose IBM for this example because it was close in price to a strike price, and not because I am proficient in setting up butterflies on IBM or would recommend this trade.

Whichever tactic I employed, the butterfly's expiration profit-and-loss (PnL) chart would have a characteristic tent shape. The red line outlining the tent-shape below is the profit or loss to be expected at expiration if IBM is at that particular price point. Many butterfly traders--most that I know--close out their butterflies before expiration. The white line shows the theoretical profit or loss each day if IBM were at that price point. That line can lift or fall lower during the day, depending on whether implied volatilities fall or rise.

Tent Shape for a Butterfly:

What can we tell from a quick look at this chart? We can tell that the butterfly will have maximum profit at expiration if the IBM were to be at 185 at December's expiration. We can tell that expiration breakevens are at 177.95 and 192.05, with losses to be anticipated if IBM is below 177.95 or above 192.05. (Actually, this chart does not include commissions, so the expiration breakevens would be a little narrower than is depicted here.) We can also add up the probability of profit at expiration. This would be 13.63 percent + 20.04 percent = 34.67 percent. This would be lower than my preference for a butterfly setup, but looking at these probability-of-profits calculations immediately tells us something about the differences in a butterfly and high-probability iron condor, both of which are positive-theta (earn money as time passes), negative-vega (suffer if the implied volatilities jump too much) trades. Butterflies typically have lower probability of profits than most iron condors. Does that mean that they're worse trades? It means that it's more likely that they're going to need an adjustment at some time while the position is open. There's always a trade-off in options trading, however. The trade-off is that there's more profit to be had in a butterfly, and that extra profit means you have more to work with when you make an adjustment. Many adjustments require you to lock in a loss. With a butterfly, you still have plenty of profit potential after locking in a loss. With an iron condor, the initial profit potential is smaller, and locking in a loss more painful. The iron condor just isn't as flexible a trade.

What else can we tell from looking at this chart? We can tell that our loss won't be infinite but is capped at a certain level, where the red expiration lines flatten and extend horizontally. This translates into a limited loss. Sizing requirements might not allow you to see this precisely, but that expiration loss would be capped at $312.00 plus commissions for this particular butterfly, no matter how far outside the tent IBM might be at expiration. I have to stop here to give a caveat to this often-stated fact about butterflies. If you're setting up a call butterfly on an underlying that has dividends, and have an in-the-money sold call on ex-dividend day, you might be subject to having that call exercised, so that you find yourself one fine morning short some stock and owing someone dividends, too. If you're setting up call butterflies, be sure to check the ex-dividend date for your underlying and take steps to adjust if sold calls are in-the-money with little extrinsic value left on ex-dividend day. Talk to the trading desk at your brokerage if you're unfamiliar with these terms or this event.

Being able to read where that maximum loss lies becomes particularly important to the trader who adjusts butterflies somewhat creatively, perhaps by adding other butterflies that might step on the wings of the original butterfly, rolling out one of the sold strikes or rolling a wing. We traders used to be able to look at the margin or buying-power effect on our strategies to determine what our maximum loss would be. However, a strict interpretation of FINRA rules for what constitutes a true butterfly requires that wings be equal distance away from the central strikes. Some of those more creative ways of adjusting butterflies in order to widen the expiration graph or lower delta-related risk, for example, will result in wings of different widths. In our IBM example, imagine that we later adjusted that butterfly by rolling half the 185 puts to 175 and all the 175 puts to 170. Now we have 10-point wide wings on the topside and 5-point wings on the bottom side. Those wings aren't equidistance from the sold puts, and, unless FINRA has recently succumbed to pressure from brokers to change outdated definitions, fit no FINRA definition of a complex strategy. On many, and maybe most brokerages these days, that would require margin to be held on both sides. Margin no longer equates to true risk--unless you're someone who can manage to close out both the upside portion and the downside portion for maximum loss, which is possible, I guess. However, that flattened red line will show you the true risk at expiration.

This article is stretching out to be longer than anticipated, so we'll stop here and proceed next week with discussions of the "today" line and how we can use this PnL or Analyze chart to test adjustments we're considering. Happy Thanksgiving to all in the U.S.!