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
Please note: This analysis holds true for every conceivable option position, and is not specific to the butterfly.
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Very detailed explanation of how the value of a butterfly spread is determined. Thank you.
I do not really have any profound idea on this, but would only comment then that this is simply a low risk low reward play. Profitability, quite hard to predict. The many uncertainties involved are no less than the calendar.
After commission and expenses, is it worth the time? For the very experienced butterfly trader, they’d probably say “yes”. But for me, this question is one of the first things that came to mind after reading this blog post.
Hello Wayne,
Here are the problems from my perspective:
1) You opened a calendar trade as a day trade. Then, refusing to accept a loss, you converted it to a butterfly – although I hope we now agree that you did not do that for the right reason [We convert a calendar to a butterfly when we no longer believe that IV is going to increase. Or to reduce risk when IV has been declining and we lost enough by being long vega. It has nothing to do with whether the market is moving in the correct direction for your trade]. There is no other good reason for this conversion. Far better to exit when the trade premise (quick profit) did not come true.
2) Trading options, especially spreads, for day trades is not efficient, Commissions are too high and slippage is terrible.
3. Yes, flys and calendars are uncertain trades. And you add to that uncertainty by trading OTM spreads, which require the market to move in your preferred direction. But the biggest difference between these plays is VEGA. Sometimes the calendar is good because IV for the two months is very different from ‘normal’ and you want to take advantage of that. Sometimes IV is just ‘low.’ To me, people choose a calendar spread far too often. By that I mean they don;t have a good reason for choosing it over alternatives. I am no calendar spread expert, and seldom trade them.
4. Is it worthwhile? Not to a day trader. But if you buy an OTM position because you are betting on direction, then yes, it is worthwhile. If you get your move, you will earn some money. How much money depends on the timing of the move.
5. If you plan to trade a butterfly, you have to accept two facts: One. They are inexpensive. That’s good. Two. Profits never get near the theoretical maximum unless you hold to the bitter end. If you want the big win, you will have to wait it out. But if you continue your ‘day trader’ mindset, then there has to be an acceptable profit level. There is nothing wrong with buying a butterfly @ 40 cents and selling it at 70 cents. That’s a big percentage profit and suits the short-term trader’s goals. However, if you trade this as an iron condor-type of trade – a trade where we plan to own the position for awhile, then that is an entirely different mindset.
It is not the butterfly spread that is the problem in this instance. It is that you made a day trade and did not like that it was not working. That’s the problem. Day traders have to be day trades with winning and losing trades.
Then you convinced yourself to use the position as an early hedge for a different position. Then you changed your mind and converted to a butterfly (becasue I wrote a blog post on that idea) – but you did it for the wrong reason. Then you have a position with lots of commissions and it is a trade you don’t really want to have in your portfolio. Maybe today’s market decline will help a little, but this is still quite far OTM.
My comment about the butterfly trade not worth the time has nothing, absolutely nothing to do with my losing calendar & later conversion into the fly. I was commenting strictly on a brand new butterfly trade.
But thinking back about the losing calendar trade, perhaps the “best” thing I should have done was to just exit that position and take the loss.
Wayne,
Sorry about my misinterpretation.
The butterfly is very different from most other option trades. Cost is small and so are profits. That makes commissions and slippage far more important. I avid this strategy and prefer the similar condor trade. But, it is always a matter of individual trader preference.