• Trading 101: Constructing an Iron Butterfly

    by  • May 14, 2013 8:15 am • Trading 101 with Peter Bryans • 0 Comments

    It is May expiration week in the options world, and therefore I figured it would be appropriate to introduce a lesser-known trading strategy. To begin, I want to highlight a rather unique phenomenon that pertains to options trading, known as “pinning”. Sometimes (but certainly not always) a stock’s closing price on the Friday during expiration will be very close (or even exactly on point) to what is known as the “max pain” strike. This strike is where option buyers stand to lose the most amount of money—i.e. it is where open interest represents the largest number of contracts that were bought-to-open on one of the option exchanges. When this occurs in large trading blocks (where a large number of contracts are purchased at once) the market makers on the floor of the exchange (who are there to provide liquidity) will generally be short the majority of the contracts, while the buyer will be long the contracts. In other words, the market maker will be the one selling these contracts to the trader who bought-to-open either the call or put contracts. What is not known by many is that these market makers can “pin” a stock to its “max pain” strike. Why would they do this? Well, they stand to benefit the most from these options expiring worthless, as they get to keep the full premiums collected from selling these contracts.

    Back in January, our Senior VP of Research, Todd Salamone, noted how Apple (AAPL) had a high probability of pinning its $500 level, as this was the max pain strike. Sure enough, AAPL closed at exactly $500 on the Friday of January expiration (1/18). Now, the question to ask is: how can we benefit from this “game” that goes on with the market makers during expiration week? The iron butterfly is a unique option trading strategy, which incorporates the use of spreads, allowing the trader to take in a net credit for the trade. The maximum profit is achieved if the stock closed at exactly one of the strikes. Let’s take a look at an example.

    Below is the current open interest for McDonald’s (MCD). You’ll notice that the largest amount of open interest resides at the 100-strike. Currently, MCD is trading just around this level (chart featured below the open interest graph). Let’s assume two things: 1) the open interest at the 100-strike is bought-to-open and 2) we expect MCD to close at $100 or very close to this level on Friday. So how do we capitalize on the trade? We initiate an iron butterfly trade.

    (courtesy of StockCharts.com)

    Constructing an iron butterfly may seem confusing at first, but to those familiar with spreads in the options world (both credit & debit spreads), it will be relatively easy to understand (I’d review the embedded links in the prior sentence). An option chain for the May expiration is featured below—calls are located on the left (symbols are in green and yellow) and puts are on the right. Listed next to the option symbols we have the current open interest, bid, and then the ask (offer) price (reading from left to right). We are going to initiate two different types of spreads.

    (courtesy of eSignal–click to enlarge)

    First, we will simultaneously sell the 100-strike put and buy the 95-strike put. The 100-strike put is bid at 0.41, and the 95-strike put is offered at 0.04. This creates a net credit of 0.37 (0.41-0.04). This is how much we will take in for this particular spreads—the 95-strike put is purchased so that it caps our losses, should MCD move lower than we ever anticipated (as a side note—we could also purchase the 97.50-strike put to take in less credit, but I’m using increments of 5 on the strikes to keep things simple).

    The next leg of the iron butterfly trade is to sell the 100-strike call and buy the 105-strike call. The 100-strike call is bid at 0.80 and the 105-call is offered at a mere 0.02. This creates another net credit of 0.78 (0.80-0.02). In total, our net credit received was 1.15 (0.37 for the put spread, and 0.78 for the call spread). Our brokerage account has just been credited 1.15 for each iron butterfly trade that we initiated.

    We are short the 100-strike in each leg of the trade—and calculating our breakeven levels is simple. Given a net credit of 1.15, our upper breakeven level is $101.15, while our lower breakeven level is $98.85. If MCD finishes above $101.15, we have the potential to lose up to (but not more than) $3.85—this is due to the fact that we are short the 100-strike call, but being long the 105-stirke call caps our losses at this level. The same calculation applies to the 100-strike put and 95-strike put—our breakeven level on the downside is $98.85, and the most we can lose is $3.85 because we are short the 100-strike put, but also long the 95-strike put as protection. Maximum profits are achieved if MCD closes at $100 exactly by the end of trading on Friday, May 17th. This is where we anticipate the stock will get pinned.

    While this strategy seems like a “lock” there are a couple of caveats to trading the iron butterfly. First off, it is very likely that you will be assigned on one of the options that you are short (either 100-strike call or 100-strike put), should one of the options be in-the-money (ITM) during the day on expiration Friday. This will require you to either sell the shares (on the call) or buy the shares (on the put) if the option holder exercises their contract. Another thing to be aware of, (this only pertains to trading the butterfly on expiration Friday) is that if you are assigned on both legs of the trade, then there are certain broker restrictions that could apply—specifically, these restrictions pertain to “day trading”. Many brokers will only allow you to open and close a position (within the same trading day) up to 3 times in any consecutive 5 day period. So, if you are selling the 100-strike call and 100-strike put on the same day, and then both of these options are assigned to you, this could count as opening and closing a trade within the same day and thus would be 2 of your 3 allowable “day trades” within a 5 day period (check with your brokers because the specifics can vary from service to service). Just something to be aware of, as you definitely don’t want to get blindsided by something you did not know.

    Even if you don’t trade an iron butterfly, the concept of “pinning” is likely one of the lesser-known elements of options trading. Hopefully you have found this information useful. Good luck out there.

    About

    Peter Bryans joined the Schaeffer's Investment Research trading team as a Trader in April, 2012. A graduate of the Fisher College of Business at The Ohio State University -- where he concentrated in Finance -- Peter previously held internships with an insurance broker and a wealth-management firm. In his current role, Peter trades a variety of our real-time option services and also hosts our "Options Apprentice" weekly webinar presentations.

    http://www.schaeffersresearch.com

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