Trading Butterflies

The Butterfly is an option position that is composed of 2 vertical spreads that have a common strike price. In other words, butterfly trading involves an opening position where options (either calls or puts) are bought (or sold) at 3 different strike prices. The way in which these options are created makes the butterfly a position that has both limited losses and limited profits, and is considered a neutral market trading strategy.

The Long Butterfly can be created using either all call options or all put options. Due to put-call parity, a long butterfly created using call options will behave like a long butterfly created using put options. In other words, it doesn’t really matter whether you use calls or puts to create your long butterfly. Our example here will focus on the version using call options.

Buying an In-the-Money (ITM) call option, selling 2 At-the-Money (ATM) call options and buying another Out-of-the-Money (OTM) call option can create the long butterfly. This is actually a combination of 2 opposing vertical spread options, hence why the butterfly is also known as the butterfly spread.

Combining the profit profile of these 4 call options, you will find that if the stock price falls, you will face limited losses (which is the initial premium you paid for the entire butterfly trade). Similarly, if the stock price climbs too high, you will also face limited losses. However, if the stock price stays around the vicinity of the ATM option strike price, you will receive limited profit.

This makes the long butterfly a good neutral option strategy for low volatility, since you are betting on the stock price not moving much in order to collect maximum profits. It is also a low-risk strategy, since your losses are limited if the stock crashes or climbs unexpectedly. Unfortunately, this is accompanied by limited profits as well. As has been mentioned above, the long butterfly can also be created using all put options instead of all call options.

A Short Butterfly is the exact opposite of the long butterfly. Instead of buying an ITM call, selling 2 ATM calls and buying an OTM call, a short butterfly is constructed by selling an ITM call, buying 2 ATM calls and selling an OTM call. As before, the short butterfly can be created using all put options instead of all call options.

The short butterfly’s profit profile is the opposite of the long butterfly’s. If the stock price falls, you will receive your maximum limited profits (which is the initial credit premium you received when opening the short butterfly position). Similarly, when the stock price climbs, you will also receive limited profit. However, if the stock price doesn’t change much, you will face a loss, though that loss is limited as well.

As you can see from the above description, the short butterfly is meant to be a strategy that is high in volatility but neutral in direction (i.e. you expect the stock to move a lot, but do not know in which direction). As a side note, this might not be the best strategy for you if you are indeed expecting high volatility and are uncertain in stock price direction. Both the Straddle and the Strangle strategies also have the same lean towards high volatility and neutral direction, but with the extra benefit that they have the potential for unlimited profit. However, the benefit of the short butterfly is that it is a credit position where you pocket the initial premium when creating it.

One warning about both long and short butterfly trading: these positions involve buying and selling options at 3 strike prices. For most option brokers, this means you will be paying 3 commissions to open the position, and another 3 commissions to close it. You will need to consider these extra commissions (which differ from broker to broker) when trying to determine if the butterfly will be profitable for your circumstances. OptionsHouse lets you place spread trades that are up to 4 legs for only $14.95 for any number of contracts. If you choose to do this type of trading, we highly recommend opening an account with OptionsHouse.

To learn more about option trading strategies, visit http://www.clarkfinancial.com/option_trading_strategies.html

Key to Trading Success: Ignore Nature’s Laws?

The following is excerpted from Robert Prechter’s Independent Investor eBook. The 75-page eBook is a compilation of some of the New York Times bestselling author’s writings that challenge conventional financial market assumptions. Visit Elliott Wave International to download the eBook, free.

By Robert Prechter, CMT

…The natural tendency of people to apply physics to finance explains why successful traders are so rare and why they are so immensely rewarded for their skills. There is no such thing as a “born trader” because people are born — or learn very early — to respect the laws of physics. This respect is so strong that they apply these laws even in inappropriate situations. Most people who follow the market closely act as if the market is a physical force aimed at their heads. Buying during rallies and selling during declines is akin to ducking when a rock is hurtling toward you.

Successful traders learn to do something that almost no one else can do. They sell near the emotional extreme of a rally and buy near the emotional extreme of a decline. The mental discipline that a successful trader shows in buying low and selling high is akin to that of a person who sees a rock thrown at his head and refuses to duck. He thinks, I’m betting that the rock will veer away at the last moment, of its own accord. In this endeavor, he must ignore the laws of physics to which his mind naturally defaults. In the physical world, this would be insane behavior; in finance, it makes him rich.

Unfortunately, sometimes the rock does not veer. It hits the trader in the head. All he has to rely upon is percentages. He knows from long study that most of the time, the rock coming at him will veer away, but he also must take the consequences when it doesn’t. The emotional fortitude required to stand in the way of a hurtling stone when you might get hurt is immense, and few people possess it. It is, of course, a great paradox that people who can’t perform this feat get hurt over and over in financial markets and endure a serious stoning, sometimes to death. Many great truths about life are paradoxical, and so is this one.

For more information, download Robert Prechter’s free Independent Investor eBook. The 75-page resource teaches investors to think independently by challenging conventional financial market assumptions.

Robert Prechter, Chartered Market Technician, is the world’s foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

Does Gamma Matter to an Average Options Trader?

What is Gamma?

Gamma measures the change in delta of an option as the underlying stock price changes. More specifically, gamma is the change in delta for every point change in the underlying stock. Therefore gamma can be used as a measurement of risk, particularly for larger positions.

How Gamma Behaves in General

Gamma increases as the stock nears the strike price, and decreases as you get further from the strike price in either direction. Gamma is positive for both calls and puts. Although that might seem confusing, it begins to make sense when you look at the big picture. As a stock price increases, the call deltas increase and approach 100. Meanwhile, the deltas of the puts also become more positive as the stock price increases. Only this time, because puts have a negative delta, the more positive the delta, the closer it will be to zero.

How Gamma Behaves Closer to Expiration

The closer the options get to expiration, the more the deltas tend to approach 0 and +/-100. As you near expiration the range from 0 to 100 is more concentrated. The gamma increases dramatically as the difference between the strike deltas becomes more pronounced. At the same time, at-the-money options rapidly gain gamma, and out-of-the-money options lose it.

Gamma and the Professional Trader

Seeing how rapidly the delta changes near expiration makes it easier to appreciate just how important of a tool it is for professional traders to carefully monitor their positions. The ability to use gamma to anticipate the change in delta is what makes it such a valuable measure of risk. By looking at the overall gamma, traders can see at a glance how much longer or shorter their position will become given a certain move in the underlying stock.

In our article on theta or time decay, we made the point that an option position either benefits from the passage of time or from market movement, but not both. In this sense, gamma is considered the flip side of theta because if time hurts a position (i.e., negative theta), price movement (i.e., positive gamma) will help it and vice versa.
For example, the short straddle is a position that’s hurt by market movement but helped by the passage of time. The straddle writer wants the market to remain steady because the more the underlying moves, the more likely it is that the position will lose money. In contrast, a person holding a long straddle is in a race against time hoping to see the market move before expiration.

Although gamma, as a risk measurement tool, is more useful to professionals who manage large positions, an understanding of the concept can certainly enhance every trader’s understanding of option price behavior. To learn more about how to trade options like a professional trader, visit http://www.optionsXplained.com

How to Put Time on Your Side When Trading Options

The old adage that time is money holds particularly true when trading options. That’s why it’s very important to understand how theta works, and the affect it has on an option price. Theta is the Greek letter used to represent the impact of time on an option’s value. All options lose value, as they get closer to expiration. However, the rate at which an option contract loses value is primarily a function of how much time remains until expiration. Options tend to lose the most value in the final 30 days before expiration. At that point, the price decay accelerates.

Only the extrinsic portion of an option’s value is subject to time decay. An in-the-money option will retain at least its intrinsic value until expiration. In other words, if an underlying stock is trading at $33, the 30 calls will always have at least $3 of intrinsic value whether there are 3 or 300 days remaining until expiration. Any value above $3 will be extrinsic value and therefore subject to time decay.

Theta, or time decay, is usually expressed as a negative number to represent the loss of value as time passes. Since the time remaining on an option can never increase, time decay is a one-way street. Thus, if the theta is given as -.28, they option contract will lose $0.28 per day in value.

However, it is important to note that theta changes over time. Assuming the price of the stock doesn’t change, an out-of-the-money $2.75 option with a theta of -.15 will be worth $2.60 tomorrow. At that point, the theta may only be -.12. If so, the option will only be worth $2.48 the following day if prices remain constant. Gradually, the value of the option will approach zero as long as it remains out-of-the-money.

What an Option Trader Needs to Know

At-the-money options have the highest extrinsic value. For this reason, these options also have the highest thetas. Deep in- and out-of-the-money options have lower thetas because they have less extrinsic value than at-the-money options. The less value they have, they less they can lose through decay.

The only way to have a positive theta position is to be short options. This makes sense when you consider that short option positions tend to do best in stable markets. Wide swings up or down will hurt these positions. Only the passage of time will help. Neutral strategies like the long butterfly also benefit from the passage of time. The less time to expiration, the less chance the underlying stock has to move up or down into unprofitable territory.

Every option position represents a trade off between time and market movement. You can’t benefit from both. If the passage of time helps a position, price movement will hurt it and vice versa. In Greek terms, price movement, the flip side of theta, is known as gamma. Any position that has a positive theta (i.e., a position that benefits from the passage of time) will by definition have a negative gamma. Similarly, a negative theta position (i.e., one that is hurt by the passage of time) will have a positive gamma. To learn more about how to use theta to your advantage when trading options, visit: http://www.optionsxplained.com

How Implied Volatility Affects Options

Have you ever bought an option, had the underlying security move the direction you hoped, and still lost money on the trade? If so, chances are you owned an option contract that saw a drop in its implied volatility. Implied volatility is an important component in the price of an option, and understanding how it affects the price of a contract can make the difference between making and losing money on a trade.

Implied volatility represents the expected volatility of a security over the life of an option. As expectations change, option prices will also change accordingly. Implied volatility is affected by the supply and demand of the particular contracts, and by the market’s expectation of potential price movement. As expectations rise, or as the demand for an option rises, implied volatility will also rise.

Knowing the current implied volatility of an option, and its likelihood to either rise or fall, will greatly increase your odds of successful options trading. Much like stocks, the idea for implied volatility is to buy low and sell high. If you are going to take a net long position in an option, such as buying puts or call, you want to buy when implied volatility is likely to increase. If the implied volatility is unusually high, and likely to decline, you’ll want to be a net seller of the contracts. It’s also important to note that implied volatility isn’t the same for all contracts on a given security. Each strike price and expiration will have its own implied volatility.

Even though implied volatility can change quite often and vary from contract to contract, there are a few rules of thumb you can follow. In general, implied volatility will rise prior to an earnings report, or some other news item, and then fall immediately after. Options with strike prices near the money will have larger swings in implied volatility than those who are farther into, or out of, the money. Front month contracts with little time until expiration will see less implied volatility changes than contracts with a longer time until they expire. Finally, implied volatility will run in cyclical trends, so much can be learned from looking at a security’s volatility chart and comparing its current level to historical levels.

Taking the time to research an options implied volatility is just as important as researching the direction of the underlying security. An understanding of how to use implied volatility is one of the big differences between professional traders and speculators. To learn more about how to use implied volatility to your advantage, visit: http://www.optionsXplained.com.

Why Most Option Traders Lose Money

The number one reason why most option traders fail is they rely solely on market timing for success. If you’re using options simply as a leveraging tool to make more money on the predicted movement in a stock or index, you’ll have many trades go in your favor and from time to time you’ll experience fantastic gains. However, if you’re simply buying calls or puts based on what you expect the underlying stock to do, your odds of long term success as an options trader are very limited.

There are two main reasons why this options trading strategy is unlikely to make you money over a long period of time. First of all, accurately picking tops and bottoms is difficult at best, especially to do it on a consistent basis. Second, and more importantly, the movement of an option, and its underlying stock, aren’t always proportional. In other words, you can be correct on the direction of the stock, and yet not make much money. In some cases, you will even lose money on your options.

Those who lose money, even when they were correct on the direction of the stock, do so because they don’t understand how implied volatility and time decay affect the price of options. Time decay is easy to understand. Your option expires on a finite date. Each day that passes, the option loses some of its extrinsic value that’s related to time. So, if you’re right on the direction of movement, but the movement is slight, and over a long period of time, you may lose money on that trade.

Understanding implied volatility is a bit more complex, and a lot more critical to your ability to make money as an options trader. The main thing to remember is other that buying an option and then having the implied volatility drop will harm the price of your option.

Implied volatility, and how successful options traders use it, is a subject too lengthy for this article. If you’d like to learn more about implied volatility and how to make money with options, visit http://www.optionsXplained. We can show you how to be a successful long-term trader, rather than a trader who eventually loses their money trying to predict stock price movements.

How to Make Money Trading Stock Options

Many investors view trading options as a highly leveraged way to take advantage of movement in the price of a stock or index. However, options trading can also be used to generate regular monthly income. The basic premise is that option prices decline as they near expiration; therefore you can make money being a net seller of options.

The most basic strategy for making money with options is writing covered calls, which is fine to create some extra income in your stock portfolio, but we’re looking to earn a regular monthly income. To make money each month, we employ several different strategies and adjust the trades as necessary to minimize risk. The use of each strategy will vary depending upon market conditions, movement of the underlying security, volatility, and time until expiration, etc. While we’ll use several different option strategies, all of the strategies are multi-leg or spread trades, which means we’ll have at least two, and as many as twelve trades going at one time. The other similarities in the strategies is that we’ll always be a net writer, or seller of puts and calls, and our goal will always be to make money on the time decay of the options.

You may have heard the names of the spread trades used to make money with options, such as butterflies, condors, box spreads, calendar spreads, reversals, straddles, strangles, etc. Each of those trades work best under certain market conditions. Each of those trades also requires monitoring and adjusting in order to retain profits and protect against risk. This may all sound a bit overwhelming, but once you learn the overall characteristics of each trade, and when to use it, it will become quite clear and your trading will become second nature. In addition to being much easier than you may think, the amount of starting capital you’ll need to start making money with options trading is surprisingly low. I’ve seen new traders take the time to learn the process, and with less than $1,000 in start up money, makes themselves a very comfortable living, while working only a couple of hours each day from home.

To learn more about how to make money trading stock options, visit http://www.optionsXplained.com. With a few days of self study, and a small amount of start up capital, you can be earning a comfortable living from home. We’ll walk you through the process in an easy to understand, step-by-step, fashion.