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.