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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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  • Options: The Iron Butterfly Strategy

    The curiously-named "iron butterfly" is a complex strategy offering limited losses and limited profits. It is an expanded version of the basic butterfly (two separate spreads offsetting one another). The "iron" version is a combined straddle consisting of four options instead of the butterfly's three.

    An iron butterfly can be either long or short. The long version consists of a long call and long put at the same strike; and a lower-strike short put plus higher-strike short call. For example, General Mills (NYSE:GIS) was worth $49.40 per share on August 3. At that price a long iron butterfly could be created with the following contracts:

    Long 50 call @ 1.00

    Long 50 put @ 1.60

    Short 47.50 put @ -1.54

    Short 51.50 call @ -0.45

    Net credit = -0.61

    In a short iron butterfly, the positions are reversed; for example for GIS a short iron butterfly could have been constructed with the following:

    Short 50 put @ -1.54

    Short 50 call @ -0.96

    Long 47.50 put @ 0.57

    Long 51.50 call @ 0.49

    Net credit -1.44

    In this case, you get $144 paid to you before trading fees. For some traders, the limits on both profit and loss are advantageous. However, this strategy ties up capital with margin requirements, and the farther away expiration is, the longer this applies. So the question should be whether this strategy is worth the limitations, not to mention the need to monitor constantly. If you are not sure about the current volatility of the market, an iron butterfly is a play that could make sense, long or short depending on which direction you believe the underlying is most likely to move, and to what degree.

    Swing traders might also find iron butterflies attractive in some instances, although these traders are more likely to use single option contracts or synthetics to play the swings while holding down risk exposure. For most traders, the small window of possible profits make this strategy less attractive than many others.

    Although evaluation of the iron butterfly is based on prices as expiration approaches, it's more realistic to expect positions to close as they become profitable. As long as short options are closed first or together with corresponding long options, the balance is maintained. However, if long options are closed first, two consequences occur. First, margin requirements increase; second, the exposure of short options replaces the previous long-short balance, taking risks much higher.

    The collateral requirement for any butterfly generally is equal to the strike difference between long and short sides. To review how collateral works in this position or any other, download the free CBOE report at CBOE Margin Manual.

    Michael Thomsett blogs at the CBOE Options Hub and several other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website

    Tags: GIS
    Aug 03 8:39 AM | Link | Comment!
  • Options: Yield Calculations On Covered Calls

    When you write covered calls, greater profits will be earned by writing several two-month positions per year, than from writing one covered call with the longest time to expiration. Time decay for further-out options is quite small, so writing options more than a few months away is equal to lost time. Based solely on option premium profits, focusing on short-term ATM or OTM contracts produces impressive annualized returns.

    An example of the covered call and how to identify profit, loss and breakeven points: On June 9, 2015, you bought 100 shares of General Mills (NYSE:GIS) @ $54.25 per share. On July 31, 2015, shares are worth $58.53, a paper profits of $4.28 per share.

    You are considering selling a covered call to earn current income. Based on the 4.28 point profit this grants you flexibility in strike selection. Using a strike of 60, you compare two calls. The September 2015 contract (49 days to expiration) is at 0.72. The January 2017 call (540 days) is at 3.05, more than four times more valuable than the September call. Adjusting for trading costs of about nine dollars, the dollar values of these are reduced to about 0.63 and 2.96.

    But does this make the later-expiring call more profitable? No. To make these two choices comparable, the net has to be annualized. Based on the strike of 60 as the most consistent and reliable price to calculate net return (as the price the stock will be sold if and when exercised), initial return for each is:

    Sept. 2015 call: 0.63 / 60 = 1.05%

    Jan. 2017 call: 2.96 / 60 = 4.93%

    Because the holding period to expiration is so different for both of these, they can only be accurately compared by annualizing the return. This reflect both outcomes as if the position were left open for exactly one year, or 365 days:

    Sept. 15 call: 1.05% / 49 days x 365 days = 7.82%

    Jan. 2017 call 4.93% / 540 days x 365 days = 3.33%

    This calculation should be performed only for the purpose of comparison, and not to estimate expected overall returns from writing covered calls. However, when comparing these two different contracts, the 49-day shorter-term option is more profitable than the 540-day contract. By writing a series of short-term options, exposure time is shorter and time decay is fast. In fact, during the last two months before expiration, time decay occurs at its fastest rate, which is why the seemingly small net return from short-term covered calls comes out better over time.

    Another way to look at the difference is to base annual dollar return on today's value. The 49-day contract yields $63 after transaction costs. If this were repeated 7 times during the year, it would result in $441 of net pre-tax income. In comparison, the $296 earned over 540 days is equal to about $200 per year ($296 / 540 x 365) - less than half the annual net income from writing a series of two-month covered calls.

    Michael Thomsett blogs at the CBOE Options Hub and other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website

    Tags: GIS
    Aug 02 8:55 AM | Link | Comment!
  • Options: Delta Neutral Trades

    A delta neutral trade is one in which a long and short options contain offsetting delta so that the net delta is at zero. Delta is a measurement of the degree in an option's price movement when the underlying moves.

    The theme of delta neutrality can refer to many differently constructed strategies including spreads (covered and uncovered) and straddles. When an option position is covered with long stock (one short call offsetting 100 shares of stock), the delta neutral creates an equivalent stock position. This position moves up or down and tracks the 100 shares synthetically, creating a form of leverage.

    The delta neutral accompanying long stock in theory wipes out risk on both sides of the option trade (the long has no market risk because it is paid for by the short; and the short has no market risk because it is covered). However, as volatility changes, so will the relative risks of each option. If the risk does offset at the point of entry, traders have a great advantage in being able to react to movement in either direction (or both). The risk applies at the time of entry and subsequent movement can lead to rolling, closing, and expiration.

    One variety of this concept involves two short options, one call and one put. The theory behind this is that offsetting exercise risk cancels out in the same way as a covered long and short position. But this is not accurate. Exercise risk exists separately for both sides in a trade of a short call and a short put. It is not neutral. Exercise of either can wipe out the initial credit received and exceed that credit by many points. Making matters worse, both shorts can be exercised when the stock moves first in one both direction and then in the other. For example, a short call is ITM on ex-dividend date and is exercised; and then after ex-dividend, the stock price falls and by expiration, the short put is also exercised. The risk is especially severe when the two-short position is a straddle. One or the other of these options will always be ITM. In comparison, a spread may involve two sides, each OTM. Whenever using short uncovered options, the collateral requirements have to be kept in mind as well.

    It makes more sense to involve delta neutral trading in positions such as the synthetic short stock, consisting of one long put and one short call. The short call pays the cost of the long put, and the short call may be covered (by also owning 100 shares of stock). What is the rationale for this position? The synthetic short stock strategy sets up a situation in which, if the stock price rises, the call grows in value and could be exercised. If you own 100 shares, this outcome is covered. If the underlying falls, the long put will increase in value. Any loss in the stock is offset point for point in intrinsic value of the put. The put can be closed to take a profit offsetting stock losses, or exercised so the stock can be sold at the strike.

    This strategy makes sense if you are concerned about downside risk but want to hold onto the stock. For a stock paying an annual dividend above 4%, for example, this is a respectable yield. For that reason, setting up a delta neutral position through a synthetic short stock strategy makes a lot of sense if you own stock, and is safer than a covered call. If you are intent on holding onto the stock because of a high dividend yield, writing a series of synthetics is another alternative. This protects against price decline while keeping ownership of stock. If the short call goes ITM, it can be closed or rolled forward.

    In any synthetic stock position, closing the long option leaves the short option open. If this is a covered call, the position reverts without added risk; but if uncovered, the collateral requirements kick in immediately. To find out about collateral for any position involving short options, check the free download at CBOE Margin Manual.

    Michael Thomsett blogs at the CBOE Options Hub and other sites. He is author of 11 options books and has been trading options for 35 years. Thomsett Publishing Website

    Aug 01 9:57 AM | Link | Comment!
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