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. Contributing analysis is by senior Optionetics strategist Chris Tyler.
A “BETTER” FLY POSITION
What can be done to make the long butterfly strategy more consistently profitable? The chances of a stock landing at the middle sold strike at expiration is not a high-probability outcome, so what might be considered during the life of the spread?
Great question. It’s important to be working with a range-bound stock or one that’s moving toward the positioned middle strike of the spread. Lower statistical volatility stocks might also provide a more consistent opportunity with the long butterfly.
Lower volatility is a good characteristic because the two embedded verticals making up the butterfly should react more favorably than a high-volatility situation. All else being equal, the in-the-money vertical position expands toward its maximum profit potential and the out-of-money loses its extrinsic value quicker than if volatility is elevated. Once a butterfly position shows some profit, various adjustments can be considered to increase one’s odds of more consistent results.
The most basic adjustment would be to close out some of the position. While the allure of holding onto a small debit in order to secure the much larger maximum profit potential is no doubt tantalizing, shares probably won’t cooperate to that extent come expiration. That said, booking profits such as an equivalent of the position’s initial risk and letting the balance work toward that lofty goal might be considered.
If the position shows a paper profit and your outlook remains more or less the same toward the stock, you may also consider adjusting into an all-call (or all-put) condor using a slightly higher or lower butterfly. For instance, say the existing one-lot long call butterfly is set up using +1 Aug 20C/-2 Aug 22.5C/+1 Aug 25C.
If shares are just above the short strike at $23, the trader might want to purchase a butterfly using +1 Aug 22.5C/-2 August 25C/+1 Aug 27.5C. This would leave the trader holding +1 Aug 20C/-1 Aug 22.5C/-1 Aug25C/+1 Aug27.5C long call condor. This adjustment will have the impact of increasing the dollars at risk. If already profitable, the position can be established for a below-market cost price and increase the chances of profits as the strategy maintains a larger reward zone within its risk profile.
If your outlook on the stock changes such that you see more volatility, you could consider opening up the butterfly into a larger one using a ratio and strike selection to your liking. The probabilities for profit will be increased but with an extra debit incurred, the additional dollar risk must be accepted by the trader.
PUT A COLLAR ON THAT BULL?
Is it true a collar position can make money in up or down markets despite having a risk profile that makes it look the same as a bullish vertical spread?
What you’ve likely heard or read is how adjusting or actively managing the collar with adjustments as shares move both higher and lower can lead to profits where losses would result otherwise. In volatile and liquid stocks in which the outlook is bullish, traders using the collar in this capacity look forward to having the opportunity to swap out the protective put when deep in-the-money (following a correction) for additional shares while simultaneously rolling the entire, now slightly larger, collar position.
Profits from the existing long put (and short call) are used to finance the purchase or accumulation of stock, and hence, the larger the corrective move, the more likely the sale of the put will be sufficient to cover the cost of additional shares without increasing the trader’s net debit exposure. The strategy boasts a smart method to transferring risk at generally opportune times.
During this kind of accumulation phase as a stock experiences weakness, traders are faced with an open loss and will increase their risk exposure upon the new-collar transaction. It’s important those factors are addressed. If shares are accumulated sparingly after a sufficiently large move (that is, an extra 100 shares [20%] to an existing 500-share position following a -20% correction), the math for selling the in-the-money puts to purchase shares and buy lower protection works such that the total dollars at stake (net debit) will remain about the same.
In addition, as this accumulation occurs, it should be noted the trader maintaining the collar position will be in a much better position on a P&L basis to buy additional stock versus the trader simply buying long shares during the corrective move and showing a much larger open loss. Further, if the stock trader chooses to buy another 20% stake or 100 shares, unlike the strategist using the collar, he or she would be increasing overall net debit exposure by that same dollar amount.
The downside for some bullish traders is the collar’s dampening of unwanted volatility (due to its limited risk construction), which helps during bearish price moves and, in recouping those open losses, can lag the profits earned by simple long stock ownership over a sharp rally, even when the execution of adjustments on the collar seem flawless. Overall, though, and as the first couple weeks of August 2011 have reinforced, the collar is a strategy worth considering.
Contributing analysis by senior Optionetics strategist Chris Tyler