optionsguy posted on 06/09/08 at 03:15 AM

For the past few weeks I’ve been blogging about butterflies. We started by introducing some major variants on this strategy, including long butterfly spreads. skip-strikes (aka broken-wing butterflies), and Christmas tree butterflies. Then we moved on to the many ways you can turn a losing long call position into a butterfly for another shot at breaking even (or even profiting) from a trade gone wrong. I’ve already explained some benefits and drawbacks of fixing your wayward long call with what I call a standard butterfly save or a Christmas tree save .

Today’s post outlines a third butterfly “save”, using split-strikes. Remember, the standard b-fly and Christmas tree approach assumes you’re still bullish on the underlying; the skip-strike can be successful if the stock stays the same, if it goes down or if it goes up – just as along as it does not go up a lot.  The trade-off for this additional flexibility is that a skip-strike will require additional capital, where the previous two did not.

Again, a skip-strike butterfly is just a standard butterfly with an embedded short spread inside it.  This embedded short spread allows us to buy the butterfly for a credit, but also brings with it a margin requirement.

Quick example recap: DRYS (Dryships Inc.)

We’ll use the same long call example I started the series with: DRYS. Imagine we bought the June 100 call on May 22nd and paid 4.60 for it; the stock was at 92.17. In the next five days (by May 27), the stock dropped to 87.14, which means the June 100 call is now at 2.5 x 2.6 with 24 days to expiration. It’s obvious this trade is not going your way. What can you do about it?

We’ve weighed three choices thus far: 1. you could sell the call and move on 2. turn the position into a standard butterfly, or 3. turn it into a Christmas tree butterfly. #2 and #3 require the stock to increase in price, so you’ve got to still be bullish for those to work. If you’re feeling bearish, you might want to consider skip-strikes as your “door #3” butterfly choice.

DRYS at 92.17

Bought 1 June 100 call at 4.60

Stock drops to 87.14

Long call drops to 2.50

Butterfly it – skip-strike version:

Buy 1 June 85 call at 7.80

Sell 2 June 90 calls at 5.50

= 3.20 net credit to the account

Already holding 1 June 100 call at 4.60

Extra credit – but also extra margin

The net credit received (3.20) for executing the two legs to complete the skip strike butterfly is more than if we just sold the long call outright (2.50) – which is nice. Actually, it yields the biggest credit of any of these butterfly-transformations — the Christmas tree version credit gave us only 0.90, and the standard butterfly 2.10.

Here’s the not-so-nice part of the skip-strike approach. If we skip the 95 sell strike from the standard butterfly and sell the 90 strike, we’re actually selling a 10-point wide short spread (100 strike minus 90 strike) and only buying (or covering) it with a 5-point wide long spread (90 to 85). The difference of 5 (10 -5) is the additional margin needed ($500) to be able to place the entire series of trades.

The position after the trade executes is long 1 June 85 call, short 2 June 90 calls, and long 1 June 100 call. If we were to enter the entire trade today, excluding the loss on the long call, the trade could be done for a net credit of .60. With the loss figured in, the total trade is done for net debit of 1.40 instead of a net credit.

The standard butterfly “save” vs. the skip-strike

Again, legging into a skip-strike butterfly brings in the most credit upfront of all our available choices (3.20) — and because of this, skip-strikes have a wider sweet spot. Specifically, the break-evens for the skip-strike are 93.60 (95 – 1.40) and 86.40 (85 + 1.40).  Compare that to legging into the standard butterfly; in that case the stock needs to be between 92.50 and 97.50 at expiration to break-even or be profitable.

Now if the stock does end up at expiration right on your sold strike (90), the max profit will be achieved for the skip-strike, 3.60 (5 – 1.40).

But as with everything in options, every new benefit usually comes with a tradeoff. While that wider sweet spot can be attractive, the skip-strike does add a lot more risk to the position. If the stock finishes above 100 stock at expiration, the max loss would be the 5 points loss on the embedded short spread plus the cost of the entire series of trades (1.40) or 6.40. Losing 6.40 hurts a lot more than selling that original long call at a loss – so you do want to think this through carefully before diving in with both feet, and it’s not an approach I’d recommend for the novice trader. One way to zero in on projections: make sure to use TradeKing’s Profit + Loss Calculator to see how the risk of the position changes as the expiration approaches.

Bottom line: you really want the stock to increase to 90 and finish there, but if blows through that 90 strike and continues on up you will have to manage or exit the position.  We do initially bring in a 3.20 net credit, so if the stock stays at 87.14 or continues on down, the skip-strike would turn out to be a better alternative than just selling the long call today.

Keep these assumptions in mind

This butterfly assumes we’re neutral to slightly bullish on DRYS. We are even okay if the stock declines in price.

I’ve said this before, but it’s worth saying again: you should also keep your expectation realistic: the ONLY time a butterfly is usually close to the maximum payout is if the stock is right at the middle strike (90) upon expiration. If it makes the move back to 90 tomorrow the butterfly will not be close to worth 5 points. My post on long butterfly spreads will give you some good background as to why this is true.

In a nutshell, here are the key differences between a standard butterfly and a skip-strike as a “repair” on a long call gone awry:

1)    Skip-strikes bring in more credit than a standard b-fly, but they require additional margin to be able to place the trade.

2)    Skip-strikes offer a wider sweet spot or break-even points for the new position.

3)    Skip-strikes also offer more upside than a standard b-fly, if the stock expires at the middle strike

This ends my series on repairing a wayward long call. The entire series assumes we just have a one contract long call to start. I should also mention: with one contract to leg into these butterflies the commission costs start to add up. These trade might make more since for someone with a larger position to start with, at least on a commission basis.

Regards,

Brian (Og)

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