We are in week five of our Real-World Trading series on a put butterfly. The stock market has been showing volatility, but within a range and this is a market environment that creates nice profits using a butterfly strategy. We chose to follow a mock trade on Cliff’s Natural Resources (CLF) using a put butterfly and so far, it has worked out well.
A put and call butterfly have the same risk characteristics; one or the other is usually used depending on the best entry prices. In review, a butterfly profits when the underlying closes near the strike price of the middle options. Remember, a butterfly consists of a long put, short two lower strike puts and long an even lower strike put. When we entered our mock trade on CLF, the stock was trading at $62.87. Since that day, the stock has traded as low as $55.72 and as high as $68.24. However, it closed Tuesday’s session at $66.78. Below is the week-to-week data for this mock trade:
August 17, 2010
CLF @ $62.87
Buy 1 Sep10 70 Put @ $8.48 [IV=50.9]
Sell 2 Sep10 65 Puts @ $5.15 [IV=53.8]
Buy 1 Sep10 60 Put @ $2.80 [IV=57.1]
Entry Debit = $98
Max Profit = $401.95
Max Risk = $98.00
Downside Breakeven = $60.98
Upside Breakeven = $69.02
August 24, 2010
CLF @ $57.81
Buy 1 Sep10 70 Put @ $8.48 [IV=50.9]
Sell 2 Sep10 65 Puts @ $5.15 [IV=53.8]
Buy 1 Sep10 60 Put @ $2.80 [IV=57.1]
Entry Debit = $98
Max Profit = $401.95
Max Risk = $98.00
Downside Breakeven = $60.98
Upside Breakeven = $69.02
August 31, 2010
CLF @ $61.10
Long 1 Sep10 70 Put @ $9.27 [IV=50.8]
Short 2 Sep10 65 Puts @ $5.23 [IV=52.8]
Long 1 Sep10 60 Put @ $2.38 [IV=55.6]
Entry Debit = $98
Current Profit = $21.00
Max Profit = $401.95
Max Risk = $98.00
Downside Breakeven = $60.98
Upside Breakeven = $69.02
September 7, 2010
CLF @ $66.78
Long 1 Sep10 70 Put @ $4.17 [IV=48.8]
Short 2 Sep10 65 Puts @ $1.44 [IV=50.7]
Long 1 Sep10 60 Put @ $0.43 [IV=59.1]
Entry Debit = $98
Current Profit = $77.00
Max Profit = $401.95
Max Risk = $98.00
Downside Breakeven = $60.98
Upside Breakeven = $69.02
Figure 1: Risk Graph and Data for CLF Butterfly
CLF shares have fluctuated widely, yet the trade never hit a point where the loss was even half the max loss. Of course, the flip side is true as well, with the gains seen small compared with the max reward possible. This is usually the case with a butterfly trade because the bulk of gains or losses occur closer to expiration. This is obvious when we look at the risk graph and the colored lines. As expiration approaches, the colored lines will move closer to the black line, which is expiration day. We can also see this by looking at the theta figure, which currently sits at $4.85. This means that all other things being equal, the trade makes $4.85 each day due to time decay alone. Last week, theta was at just $2.24, showing acceleration in time decay as time passes.
To show how time decay impacts the trade, let’s look at a 'What If?" scenario. If CLF were to close at its current price of $66.78 at expiration in 10 days, this is how the trade would result:
Long 70 put = 3.22
Short 65 puts = worthless
Long 60 put = worthless
Debit to enter = $98
Credit to exit = $322
Total profit = $224
This would be a very nice return, equating to more than 200 percent on the initial investment, in just one month’s time. Basically, as long as CLF closes at expiration between 62 and 68, we would see a profit of at least $100. The week of expiration, time decay will accelerate, but the max profit cannot be achieved until expiration. To avoid movement on expiration Friday, traders could take profits sometime during the week to lock in gains, albeit below the max.
Feel free to ask any questions or make comments on my forum. It helps all of us when questions are asked, even the simplest of questions, so please post these and I will answer them on the post or in an upcoming articles.
Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
