Options Archives

Butterfly Options, the Risks and the Rewards

I got a few responses to my post talking about my recent Apple (Symbol: AAPL) butterfly, therefore I thought I would explain a bit more.

A Butterfly option is when you buy 1 call/put, sell 2 calls/put, and buy 1 call/put. This makes a “butterfly.”

In my post I talked about how I ordered the following:

Bought 1 Call at $670 expiration Oct 2012
Sold 2 Calls at $700 expiration Oct 2012
Bought $1 call at $730 expiration Oct 2012

On the day of expiration, My P/L would look as follows:

I have over-analyzed butterfly options, but I want to pass on one major concept. It is very rare for an option to be executed early, and even more rare on non-dividend paying stocks/ETF/securities.

Why is it rare for an option to be executed early?

Options are valued as follows: Inherit value + Speculation Value. Imagine you have a $10 call and the stock is currently trading at $15 and it is 5 days before expiration. The option could be executed for $5 profit, therefore it has $5 of inherit value. The option also has “speculation value.” The stock could go up to $16 in the next 5 days or maybe more, this adds value to the option. The total option might be worth $5.14 5 days out, $5.09 4 days out, etc. Typically people sell options instead of execute them before expiration dates.

The exception is almost always dividend related. By executing an option and grabbing the stock on the day needed to secure the dividend, an option trader can collect dividends. This is most important for anyone who sells any options (whether they be in butterflies, call spreads, or naked). In my opinion it is best to avoid dividend paying stocks for most of these strategies or to buy in expiration time frames that will not include dividends (be safe).

I like the idea of trading ETFs that do not pay dividends for the butterfly strategy the most.

What happens if the options you sold are early exercised?

You will receive the payment (for example if you had sold 50 $10 calls and the stock is now $15, you would receive $10 x 100 shares per contract x 50 contracts = $50,000 received from the option exerciser and you would short $65,000 worth of stock) Note this can result in a margin call, but this is often mitigate by the fact that your bottom call has a value to cover the difference. The big “scare” here is that you may (rare) need to liquidate or exercise your options immediately if you don’t have the cash to cover for a potential margin call. Most brokers give you 1 day to cover, so that means you need to be checking your phone/computer/etc at least once a day.

Say you have a 5/10/15 butterfly and they exercise at $15 and then the stock immediately falls to $10, would I be out money?

No, when they exercise those contracts, you short the position. Therefore if the stock falls your short position would show a gain while your bottom call might show a loss. This could actually result in a gain depending on the circumstances.

There are a lot of moving parts to this equation. The big things you have to focus on though in my opinion are events that cause reasons for early exercises (dividends, mergers, etc.) and you need to be an active trader to properly protect a potential margin call.

So why trade Butterfly Options?

I have seen butterfly options that have a net cost of $.01 per contract with an up potential of up to $1.00. That’s up to a 100x return. It is unlikely you would actually hit 100x on the dot (stock would have to finish EXACTLY on the middle butterfly point), but it is viable that you could end up with 10-50x your return. In a lot of ways, butterfly options are traps. My “trap” is I capture any upswing in Apple (Symbol: AAPL) up to $700, but start losing my gain for anything over $730. Although my Apple stock does not have the potential to earn 100x on a trade, I think the likelihood of my option becoming “in the money” far exceeds the chances of a $.01 butterfly contract.

You can quickly see how the gambler mentally could be a problem with butterflies though. Put down $1k and have a chance at $100k? Although that’s technically correct, its is very common for those types of butterflies to finish worthless, but who knows maybe if you play 30 of them, one will hit (Sounds like the lottery, because in a lot of ways it is).

But let’s also not forget the best upside to butterflies, limited loss. I paid $730 for my butterfly that will effective capture all up movement from hear to $700, but if I was to just buy a $670 call (which would also do the same and capture anything above) it would cost about 2.5x more premium. I think Apple has some legs, but I’m not convinced it will blow past $700 (although it easily could). I’m hoping for a $690 – $710 finish (finding resistance around $700 breaking point).

Disclaimer: Do not try butterfly options on your own, always consult a professional to fully understand the risks and rewards. Nothing in this article or this website should ever be used as investment advice.



Butterfly Option on Apple for Oct 2012

I believe Apple is destined to head back to $700 or even above very soon. But boy look at those option chains, so expensive.

What a perfect time for a butterfly option.

What are butterfly options? Well let me give you an example.

Buy 1 – $10 Call @ expiration date ($-1.79)
Sell 2 – $12 Call @ expiration date ($1.86)
Buy 1 – $14 call @ expiration date ($-.25)

Net Cost: $.18 per “butterfly option contract.”

Now think about this, if the stock finishes at $12, the $12 call you sold and the $14 call you bought is worthless, but your $10 call is worth $2.00 and you only paid a net price of $.18. That means you made $2.00 / $.18 = 1011% return minus commissions.

Why Buy that last $14 contract?

If the stock finishes at $14 a share, you are even (Your $10 is worth $4 and the 2 $12 calls are worth -$4). If the stock continues to go up, the $14 will cover the rest (result is break even)

So what butterfly option did I buy on Apple (Symbol AAPL)?

Bought 1 Call at $670 expiration Oct 2012
Sold 2 Calls at $700 expiration Oct 2012
Bought $1 call at $730 expiration Oct 2012

Net cost? $7.20 per butterfly option contract.


If the stock finished at $700 I would walk with a cool $3,000 on my $720 (316% return).

Doesn’t have to finish exact at $700 either. If the stock finished $10 above or below $700, I would still make $2000 on my $730.

Where is my break even?

$677.20 or $722.80. Anything closer to $700 is all gravy.

Why not just buy a $670 call?

Because I think it will end somewhere around $700 (and if it does I get a much larger return by only spending $730 upfront vs $2500). Not to mention if it goes down instead, I’m out less than 1/3 of the money.

LEAP Options over Stocks

I was up over 10% this month, keyword of course being was. For those who follow my blog, you will see on a monthly basis I update with a “personal portfolio update,” letting my readers see where I stand in performance.

July +11.8%
August +12.88%
Sept: +4.54% (as of 9/20/12)

If you are a familiar with investing, odds are you will take a look at that recap and immediately identify that I am operating on a very leveraged scale. I mean 12% in a month? My account must be moving like a pinball, and honestly it really is.

But despite having up to 4-5% move on a daily basis, I still prefer trading with LEAP options over stocks. You may say that I’m playing with fire, but I see it as trying to get a fire going.

I have roughly $15,000 in my account as of today, a big step up from what I was working with at the start of this year, but relatively a small drop in the bucket when it comes to trading.

I believe that I can fairly easily hit a 10% a year return, but 10% on $15,000 ($1500) is immaterial in my eyes.

Because I am so confident that I can hit 10% a year, I want to amplify my return through leverage. With discipline I believe that LEAP options are the perfect vehicle. Highly leveraged securities but retaining a finite loss possibility.

If I had a bigger bank role, then 10% would be just fine, but I simply need to grow my account at a pace greater than 10% a year. As an FYI, Year to date I’m up 63.26%, which is insane.

The bottom-line is that to obtain such a crazy percentage, like all investments, I must take massive calculated risk.

Why am I being so Aggressive if it could turn against me?

  • I still believe I can outpace what I could do with traditional stocks
  • All investments have risk, you make the investment because you think the risks are worth it (article to follow about this)
  • My account balance is still small enough that I am comfortable taking this risk

Your “account balance is still small enough,” when will it be too large?

I believe that I will always have some port of my portfolio invested in the strategy I’m currently implementing. That being said, if I had for instances 100k in this account, a portion of my account would probably be in cover calls to take the edge off the volatility. I know this would hurt the return, but once I get myself established a little more, it will be best to mix up my portfolio into low risk/reward and higher risk/reward portions.

Why wouldn’t you just implement the strategy for the entire portfolio if you are so confident you can beat 10%?

I see cover call writing as the way the truly rich can obtain consistent lower risk returns. If my account was say $5 million, 6-10% return a year with lower risk would be the logical choice. I want to slowly work myself into a position where cover calls are obtaining a respectable return, so I will be able to ween off the high volatility. You never know when the next big crash is coming, it could be this year or 15 years from now and unless you are perfectly hedged (which tends to be a little tricky) you stand to destroyed. I would much rather lose 15% off a large amount than potentially 30+%.

Why are you writing this article?

To reaffirm myself. I am confident in my strategy, but I tend to get too caught up in the “Monthly Performance” number. As I said before, I was up a little over 10% and now I’m only up 4.54% for the month. So after taking this hit, I look at my investments and thought “I’m happy with my positions.” I still had the overwhelming desire to act, even though I don’t need to. I can’t say that each month will fall in the positive, but I still believe that my options (most of which expire in Jan 2014) will be good investments long-term.

Final Thoughts:

I plan on selling my house (Should net about $25-30k, hopefully), and I hope to have my account to roughly $50,000 by the end of 2013. If I can grow my account at a rate of 30% for 5 years, 20% for 5 years, and ultimately 10% for 10 more years, my account would grow as follows:

After 5 years – $185,646 (pre-tax and inflation)
After 10 years – $461,811. (pre-tax and inflation)
After 20 Years – $1,198,173 (pre-tax and inflation)

This implements my idea of “slowly weening off the volatility.” These calculations of course assume that I do not add any money into the account as well.

And to add contrast and really hit my idea of “trying starting a fire,” if I was just to aim at getting 10% a year:

After 20 years – $336,374 (pre tax and inflation)

Not bad, but not good enough.


JCpenney’s is Doom (Symbol JCP), Short on JCP

Revenues, EPS, traffic, and gross margins are all down. I for one am short on JCP.

The “nay-sayers” will say that their restructuring deal was a four-year plan, but frankly I feel like the results should have been extremely more positive in the short-term to have any chance of bearing fruit long-term.

How bad is it? I would argue it’s really bad.

  • Revenues in Q3-2012 are down 22.6% from Q3-2011
  • Net income for Q3-2012 was -$147m versus +$14m in Q3-2011
  • Actual traffic in the store is down for a second consecutive quarter

I could go in to more detail about margins, but those numbers are enough alone to be justification of a short to me, but then again I’m bias. I hate J.C. Penney , Kohl’s, and Macy’s. We went through the cycle of coupons and discounts and now we are into reinventing ourselves similar to Target? I’m not buying it.

J.C. Penney is a dying company to me. Increased competition and what I would call the “dying age of the mall” will slowly push a lot of retailers out of the game. I admire J.C. Penney for trying the restructure, because honestly they didn’t have much choice if they wanted to continue long-term, but what exactly do they have going for them?

I would say the only thing that can save J.C. Penney now is quality of product. I’m not going to get into specific brands, but I believe J.C. Penney is still viewed as having higher quality than competitors like Walmart and Target. I’m not sure that will stand the test of time, but quality of product should Jcpenney’s future and things might get ugly when it comes to advertising (bashing competition or implying inferior competitors).

Then again, I just don’t think J.C. Penney¬† will focus on quality, and ultimately it will become a thing of the past. If I was long on retail, I would consider target (Symbol: TGT) if it got back down in mid to high 50’s. Although I personally hope target goes up, so I can short it on resistance. When it comes to Macy’s and Kohl’s, as much as I personally hate them both, their Year on Quarter revenues did not suffer like J.C. Penney’s. I view them as an avoid or potential short (again trading on resistance).

Could J.C. Penney rally? Of course, but I currently believe it is more likely to fail than succeed, and that is enough for me to take action. I can tell you one thing though, You won’t find me shopping there.

Disclaimer: Although I personally have taken a short position on JCP, my opinion and this article should not be used for any decision making of any kind. Always consult a professional before investing.


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