Q&A
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 BROKEN BUTTERFLY?
Being relatively new to options, I’m paper trading various strategies until I thoroughly understand them and commit real capital. One position that’s stumped me is a long butterfly using two contracts (2 x (4) x 2) purchased for $1.00. The stock proceeded to dive shortly thereafter and much to my surprise, instead of a maximum loss I thought was contained to $200, the position was down more than $1,200! Can you help explain this to a slightly disconcerted newbie?
First, let’s start off with a bit of congratulations on your willingness to learn the mechanics of option trading and smart sense to utilize your broker’s paper trading platform as an integral part of that process. As for your long butterfly position, it sounds as though you have a modified version of this spread, with a larger embedded, sold vertical as your likely profit & loss culprit.
Say what? Know this: a long butterfly can have a unique risk profile with greater losses than the initial debit if the purchased vertical (either lower bull call spread or higher bear put spread) is tighter than the sold vertical component. Similarly, long butterflies can be modified with different ratios such as 1 x (3) x 2 with equal strike distances for the verticals and yield similar lopsided risk on one side of the spread.
When a butterfly goes deep in-the-money, quoted markets can be wider than normal and cause the position to show an exaggerated loss.In regards to your dilemma, the modification is often called a “broken wing butterfly.” The profit center of the butterfly, just like a regular fly, is the purchased spread minus the initial debit. But the bear call spread or bull put spread sold is designed using a wider strike distance. The result is the associated risk with that vertical will siphon the long vertical’s profits by the extra difference of the larger spread if shares jump above or below that vertical’s purchased outer wing.
For instance, if a trader purchased one — that is, (1 x (2) x1) 30/27.5/22.5 put butterfly — for $0.50, the maximum profit is the 2.5-point 30/27.5 bear put spread minus the debit. This produces $2.00 in profit at expiration if shares are exactly at the 27.5 strike. The downside is this position’s maximum loss is $3.00, or $2.50 more than the price paid for the butterfly. This is because the design of this butterfly maintains a five-point 27.5/22.5 bull put spread whose risk is double the profit of the bear put spread.
It should be noted that losses larger than what we expect from a butterfly can sometimes be attributed to temporary distortions in implieds during an abrupt move in the underlying. When a butterfly goes deep in-the-money, quoted markets can be wider than normal and cause the position to show an exaggerated loss. However, that influence isn’t going to be of the magnitude of loss with which you’re obviously concerned. Ultimately, your profit center spread would be favorably affected by the same market forces and should mostly offset the increased (paper) risk of the other component short vertical.
Similarly, if the butterfly is deep in-the-money in a stock that’s hard to borrow, the quoted markets will tend to be wide and illiquid. We’d strongly suggest staying away from those type of situations, as put/call parity doesn’t necessary hold up as it would otherwise due to the problems associated with maintaining or executing short stock. Free information is available on many financial sites online regarding current short interest statistics. In addition, your broker should be able to provide you with information and advice regarding stocks with this kind of exceptional and unwanted risk.
MATH ASSIGNMENT
With assignment of a short call prior to expiration a possibility on equity options, when should I expect this type of risk?
Equity options fall under the category of being American style, wherein and as stated there is the risk of assignment for those holding short contracts, either a call or a put. With regards to the call, the good news is that an early assignment is typically very clear as to when it might occur.
The only normal situation in which it might make sense for the trader long the call to exercise the contract is immediately in front of an ex-dividend date in order to collect the payout. This is due to the fact the call doesn’t maintain the rights of common stock and will, in effect, go down by the price of the dividend and thus forfeit that amount if left unexercised. But for the call to have assignment risk, you must also realize that the contract needs to be deep enough in-the-money to make the exercise into long stock attractive.
If the dividend payout is smaller than the corresponding, same-strike put market value, the trader would actually be better off holding the call rather than exercising for the dividend. The reason is simple enough; the process of exercising in this situation is the same as selling a call and buying long stock to establish a buy-write for the price of the dividend. As the buy-write is the synthetic equivalent of a short put, we only need look to that contract’s current market value to determine if assignment risk is high.
In other deep-call situations prior to expiration, the trader long the call doesn’t have any economic incentive to exercise the contract. At the end of the day or, more aptly, during the life of the call, it will be more cost-effective and less risky to hold a call due to its defined, limited-risk structure and reduced capital requirement compared to an equivalent position of long stock.