Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
Does 1 + 1 = 2 or
1?
Can I adjust a profitable long butterfly prior to
expiration and if so, how? Would it amount to being a smart approach for
this type of spread?
Good question. When dealing with open profits, it’s always important to consider fresh alternative positioning through the adjustment process. As far as executing goes, the simplest and a perfectly reasonable adjustment would be to lock in your profits by exiting the long butterfly in full or partially.
A return on investment of 50% to 100% prior to expiration isn’t uncommon for a long butterfly. That’s impressive in some ways, but the same profits will be a good deal less than the idealized maximum. That can be annoying. But remember the old saying: “Don’t get mad, get even.” Coupled with an appreciation for another old saying, “You get what you pay for,” traders can redirect their focus and take profits along the way rather than hold on for no good reason.
This makes a good deal of sense as opposed to simply holding onto a paper profit. Not only are butterflies generally slow to expand toward their maximum profit potential due to the razor-like precision required of shares, it’s also an unlikely outcome. Worse, those paper gains could be quick to come undone altogether. And while we may have “only” paid $0.40 or $0.50 to initiate the butterfly, lots of small losses can hurt you over the long run.
An alternative adjustment could be to add another butterfly. In this case, though, one butterfly plus another doesn’t necessarily add up to two butterflies. When a trader adds a second long fly, it’s typically designed to create an all-call or all-put long condor by adding a wing to the old fly’s center or middle strike.
For instance, a trader long an Ibm February 155/160/165 butterfly one time (1 x -2 x 1) might decide later on to buy one February 160/165/170 butterfly. The net position leaves the trader with a February 155/160/165/170 call condor (1 x -1 x -1 x 1).
Who would do this? A trader who still holds a range-bound technical opinion on shares but wishes to give the stock additional room either up or down (in this case, up) and is someone who might consider this type of adjustment worthwhile. While the new position’s maximum risk is increased and the maximum profit is reduced, the probability of a profit is increased, as they will have expanded the breakeven zone.
Another possible adjustment would be to consider taking off one of the verticals embedded in the butterfly if the technical opinion warrants such action. For instance, in our Ibm illustration, if the trader had become bearish on shares, selling the February 155/160 bull call spread would leave the trader with one February 160/165 bear call spread.
This position, like the original butterfly, will also show its maximum loss (butterfly debit + bear vertical spread width - credit received “to close” bull vertical) at expiration if shares continue to rally above the long 165 strike. However, the bear vertical will lock in its maximum profit potential if shares are below 160.
Danged if i do, danged if
i don’t
I’ve had a consistent challenge involving
the opening of option orders and getting fills that I see as acceptable.
With limit orders, I feel as though my order never gets executed until
an unwanted move in the underlying stock occurs — and then,
I’m less than excited about the position. On the other hand, if I
send a market order, I’m amazed at how often the average fill
price is worse than the quoted market. Is there anything I can do to
help with this unwanted trend with my option positions?
Part of your dilemma sounds like your trading involvement has been in lesser- or lighter-traded issues. One recommendation right off the bat would be to stick with more active and liquidly traded options. Believe it or not, they aren’t always the same and not having both conditions in place can be problematic when placing orders.
In general, sticking with stocks whose front two-month contracts trade at least several hundred calls and puts daily and whose individual quoted markets show bid/ask spreads of no more than $0.05 to $0.15 wide for options under $3.00 is something to consider when trying to get a fair fill in the market.
Another idea would be to look at conditional orders, which can be tied to either the stock or option price or both. What a conditional order does is hide your bid or offered contract from the market maker who might otherwise attempt to use your order flow to their advantage. From what I can tell about your attempts at using limit orders, you seem to have a firsthand working knowledge of that concept.
That said, conditional orders are maintained by your broker’s internal trading platform until certain conditions are met, such as the option’s offer dropping to your hidden bid price. At that time, your order is instantaneously put into the marketplace to receive a fill at the offered price.
Contributing analysis by senior Optionetics strategist Chris Tyler