Options Trading

Butterfly

Think you can peg a stock's price at expiration and want to catch a profit? Try a butterfly - its bite can be gentler than with other strategies. Butterfly spreads are traditionally done with either all calls or all puts, and involve four options (2 long and 2 short) for each spread. The expiration months and increments between strike prices for all options should be the same. Because the total cost for the 2 long options will generally be more than the total premium received for the 2 short ones, these spreads will usually be established for a net debit. Butterflies can commonly be established as a unit - i.e., 2 options purchased and 2 options sold in one single transaction.

• Maximum profit potential: limited
  You should see your maximum profit if the underlying stock closes exactly at the written options' strike price at expiration. If this happens, your short contracts will expire at-the-money and should have no value, and the long option that is in-the-money will have intrinsic value.
• Loss potential: limited on both the upside and the downside
  Your maximum loss potential is limited to the premium paid for the spread in the first place. At expiration this will occur at underlying stock prices on the upside equal to or greater than higher strike price, and on the downside equal to or less than lower strike price.
• Break-even point (B.E.P.) at expiration: Upside B.E.P. = underlying stock price = higher strike price - net debit paid for spread Downside B.E.P. = underlying stock price = lower strike price + net debit paid for spread.

Short Butterflies

A short butterfly is simply the opposite of the long butterfly discussed here. Here's an example:

• write 1 option with lower strike price
• buy 2 options with middle strike price
• write 1 option with higher strike price

We view the long side on these pages primarily because more investors take a long rather than a short position, and wait until expiration to sell it, hopefully at a profit. The potential limited profit compared to the risk of a short butterfly is not attractive, as you can see from the P&L graph.

Condor

Want to butterfly a stock, but with more chance of profit? Condors offer a bigger range of profitable underlying stock prices. Condor spreads can be done with either all calls or all puts, and involve calls & puts options (2 long and 2 short) for each spread. The expiration months and increments between strike prices for all options should be the same. Condors can be established as a unit – i.e., 2 options purchased and 2 options sold in one single transaction.

• Maximum profit potential: limited profit, if the underlying stock closes at or between the sold options' strike prices at expiration.
• Loss potential: limited to the premium paid for the spread on both the upside and the downside
• Break-even point (B.E.P.) at expiration:
  Upside B.E.P. = underlying stock price = highest strike price – net debit paid for spread
  Downside B.E.P. = underlying stock price = lowest strike price + net debit paid for spread
  
  
  

  Reversals

  Reversals are often used by savvy traders in an attempt to capitalize on minor price discrepancies between Calls and Puts. Like other arbitrage strategies, a reversal involves buying something in one market and simultaneously selling it in another to capitalize on whatever small discrepancy exists between the two.
  When options are relatively underpriced, a trader would sell stock on the open market and buy the options equivalent in the option market to establish a reversal. Theoretically, this is a strategy with very little risk because the profit is locked in immediately. The idea here is to create a synthetic long position and offset it with a short position in the same underlying stock. The synthetic long position is created by buying a Call and selling a Put with the same strike price and expiration.
  Combining a synthetic long position with a short stock position creates a reversal:
  
  
  
  • long call + short put + short stock
  • Profit potential: Limited
  • Loss potential: Limited
  • Break-even point: call price - put price = stock price - strike price