Let's look over the shoulders of some would-be butterfly traders one December morning and try to discern why they had placed the orders they did.

For the uninitiated or newby option trader, a butterfly is a complex options position. For each butterfly contract, the butterfly is formed when the trader sells two options (both calls, both puts, or a put and a call) at the same strike and buys one option at a higher strike and one at a lower strike. For example, I could establish a butterfly in the RUT by selling two 1160 puts and buying one 1110 put and one 1210 put, all in the same expiration cycle.

In a traditional butterfly, each bought (long) option is an equal distance away from the central strike. In my example, both long puts are 50 points away from the sold 1160 puts. If the central strikes you sold were both puts (the 1160 puts in my example), both options you buy would be puts, too. If the central strikes you sold were both calls, the options you buy would both be calls, too. Neither type of butterfly is preferable to the other, but some traders make a practice of choosing put butterflies if they're placing the central strike well below the current price and call butterflies if they're placing the central strike well above the current price.

If your central strikes were a put and a call at the same strike, then you would buy a long call above the central strike and buy a long put an equal number of points below the central strike. For example, I could have sold one 1160 put and one 1160 call, and bought a long 1110 put and long 1210 call. This last type of butterfly is called an iron butterfly. It's really an iron condor with the central strikes pushed together, but it behaves like a butterfly.

The expiration graph of a butterfly has a characteristic tent shape. That includes iron butterflies.

A butterfly order is usually placed as a single order. At some brokers, including mine for the account I actively trade, the iron butterfly order would be placed using an iron condor order form.

Let's look at the types of RUT butterfly trades that traders were interested in on December 26. Then let's talk about what some of those traders might have been thinking when they placed those orders.

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

This screen capture from the RUT Butterfly Spread Book at about 10:24 EST on December 26 shows that traders had butterfly orders open for DEC, JAN, and FEB butterfly trades. More orders were also open: this was just part of the Spread Book that morning.

Green orders were orders to buy butterflies and the pinkish-orange ones were orders to sell butterflies. Traders were interested in both buying and selling those butterflies. With the RUT at 1167.58 at the time, the central strikes of those butterflies were near the money (1170 central strikes), below the money (1130, 1160, and 1110 central strikes), and above the money (1230 central strikes). The wings of the butterflies were as few as five points away from the central strikes and as far as 50. Some butterflies were composed of calls and some, puts. Because of the way butterflies and iron condors are classified on think-or-swim's platform and those of many others, this spread book page didn't pick up iron butterflies.

Clearly, butterflies are flexible creatures when we're talking about the type of butterflies created by options traders.

Experienced butterfly traders can clearly visualize an at-the-money (ATM) butterfly, but let's put one of those ATM orders placed that morning up on an analyze screen.

Six-Contract RUT JAN 1190/1170/1150 Put Butterfly:

We know one thing about this trader's intentions: this trader wanted a good deal. At the time this trader had an order in to buy this butterfly for $4.10, the mid-price of this butterfly was $4.80. Especially when markets are volatile, it is sometimes possible to buy a butterfly for less than the apparent mid-price, but that's likely because there are momentary changes in the underlying's price and the implied volatilities of the options, and then changes in the mid-price. It's not likely that anyone is going to give the trader a bargain price out of the goodness of his or her heart.

We also know that the trader is looking at a "skinny" butterfly. Even at the $4.80/contract going price for this butterfly, it's cheaper than a butterfly with wider wings. However, there's always a downside to every plus in options trading. The downside here is that the expiration breakevens are relatively close together. For example, the dark blue column shows the distance the RUT might travel above and below the previous day's close if it were to make a one-standard deviation move. Some traders want their trades to be able to endure a one-standard deviation move either side of the previous close without hitting a loss bigger than the planned maximum loss since they consider such moves just standard moves or "noise."

If I were to move the date up a week, my charting program calculates that a one-standard deviation move for that period of time could bring the RUT as low as about 1142 and as high as about 1188. Both are outside the expiration breakevens for this skinny butterfly. Since some traders adjust their butterfly trades as the expiration breakevens are approached, that means that the trader of the skinny butterfly is likely going to have to adjust that trade more often.

However, let's look at where the profit-and-loss line would be at that time. Keep in mind that this would be an entry at $4.10, since we're looking at what the trader wanted to pay. While I think it unlikely that the trader was able to secure the butterflies at that price that day, what we're examining is what the trader was thinking at the time that order was placed.

Theoretical Profit-and-Loss Line One Week after Entry:

The curvy PnL line has risen into the profit zone, supposing that the volatility stays the same. At the expiration breakevens, the trade would theoretically be profitable one week later. Even if the trader waited until the RUT had moved a standard deviation either direction, the trade would theoretically be either flat or slightly profitable. Again this was assuming that the trader was able to get an extremely advantageous price and implied volatilities did not spike higher. Even at the normal $4.80/contract price, however, it's possible that the loss wouldn't be beyond the planned maximum loss at the expiration breakevens or even at the edges of a one-standard deviation move for a week.

So, what was the trader thinking? Since the order was placed well below the mid-price, this perhaps could have been a speculative trade, a "let me throw this order out there and see if it goes" sort of thing. We can surmise, too, that, once in the trade, this trader plans one of two tactics. This might be meant to be a quick speculative trade that will be exited either at planned target profit or, in the case of a disadvantageous move, when the RUT's price ranges to the expiration breakevens or beyond a one-standard deviation move since entry, or at a planned maximum loss. Barring big changes in implied volatility, the exit at the expiration breakevens would likely be for small loss, breakeven, or a small profit. This trader might have been looking ahead to another holiday week, thinking that the trade would collect time decay without as much risk, since the market would be closed for the New Years' holiday. We can see from the last chart, with the date rolled forward a week, that trade has the potential of producing a nice profit if the RUT just sits still for a week, although market makers have been holding onto time decay longer these days, especially over holidays.

I checked this theoretical trade one week later, the morning of Thursday, January 2. Price had moved to and then slightly outside the downside expiration breakeven. The PnL line was jumping around quite a bit, but a profit of $299-$539.94, including commissions both ways, was theoretically available at about the same time of the morning as the entry a week earlier. That was more than the theoretical gain predicted. I would imagine that it might have been hard to fill a butterfly order that morning, so I would factor in some slippage before I believed too strongly in that amount of profit. However, if that trader had been able to get a fair fill, even with some slippage, profit did appear to be available and might have been available even if the trader had caved to the going $4.80 price instead of paying the bargain $4.10 price.

If none of that was the trader's intention, and the trader intended to hold onto the trade until closer to expiration, that trader hopefully understood that adjustments would likely be needed. Within two weeks after entry, a one-standard deviation move could take the RUT as low as 1132.50 and as high as 1197, and the theoretical loss would be as high as 40 percent on the downside and as high as 21 percent on the upside if those levels were approached. Adjustments might include adding other skinny ATM butterflies as an expiration breakeven is approached or moving the original butterfly to a new ATM position by selling the original butterfly and buying a new ATM.

Next week, we'll look over the shoulders of other traders with other butterfly orders that day.

Linda Piazza

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