Some forum posts involve excellent questions that provide a platform for further discussion. Thank you Wayne and to everyone who contributes to the forum.
Note: The discussion includes many details. The idea is to clarify the discussion so that both less- and more-experienced traders can understand. These are the detailed discussions that set Options for Rookies apart from others.
Mark,
I just finished viewing yesterday live session recording and you commented on my losing calendar-fly conversion [Note: Position was converted from a calendar spread to a butterfly].At the time when converting to a fly, I must admit that I did not fully understand how the butterfly profits. I only thought about delta: for my 630/640/650P fly, it’s the miracle finish at 640 that grabs attention and thus my thought was any downward movement closer to 640 would be good.
Yes, that 640 ‘finish’ would be great. But, as you know, a sudden dive to that area would not be all that profitable for the butterfly. A more complete explanation of why this is true is offered below.
Anyway, I still must ask: is it good for RUT to move towards the middle short strike?
BIG ‘YES.’ It is better. But what you really want to know is whether it is profitable.
Can delta overwhelm vega on the put fly?
Delta is often more important than vega. However when things get wild, vega easily overwhelms delta.
Look at it this way. The higher the implied volatility of the options, the more likely it is that the underlying asset will make one or more substantial moves prior to expiration. Thus, no matter where the stock is priced today (even if it is right where you want it – at that middle strike), volatile stocks do not suddenly stop moving. That’s why butterfly spreads of VERY volatile stocks have little value right up to the very last day. In fact, the wide bid ask spreads would probably combine to show a bid of less than zero for the fly. And the real world bid would not be much higher than zero. To understand why this is true, consider this:
...
Mark,
I thought more about the effect of IV/price on the value of the butterfly spread. Correct me if I’m wrong.
We agree that the spread reaches its max value when the underlying is at the middle strike on expiration day. Then, I think the value of the spread depends on how IV would predict this to happen given the amount of time remaining.
When there is still quite some time before expiration day, an increasing IV actually makes the spread worth more if the underlying is still far away from the strike, because this high IV means there is greater likelihood that the far-away underlying can reach the strike by expiration day. On the other hand, a decreasing IV may not be so good in this situation because there are still many days before expiration and the low volatility implies that the underlying is not going to make big move, not likely to reach the middle strike.
Again, profitability depends on likelihood of reaching the middle strike as predicted by volatility.
Wayne,
I have a lot to say on this.
We are talking about ‘likelihood’ and ‘probability.’
I’ll use a blog post to reply. Sorry to keep you waiting.