Butterfly control on options
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The forecast, therefore, must be for "high volatility," i. Strategy discussion A short butterfly spread with puts realizes its maximum profit if the stock price is above the higher strike or below the lower strike on the expiration date. Butterfly spreads are sensitive to changes in volatility see Impact of change in volatility.
The net price of a butterfly spread falls when volatility rises and rises when volatility falls. Consequently some traders establish a short butterfly butterfly control on options when they forecast that volatility is "low" and will rise. Since the volatility in option prices typically rises as an earnings announcement date approaches and then falls immediately after the announcement, some traders will sell a butterfly spread seven to ten days before an earnings report and then close the position on the day before the report.
Success of this approach to selling butterfly spreads requires that either the volatility in option prices rises or that the stock price rises or falls outside the strike price range. If the stock price remains constant and if implied volatility does not rise, then a loss will be incurred.
Patience and trading discipline are required when trading short butterfly spreads.
Trading discipline is required, because, as expiration approaches, "small" changes in the underlying stock price can have a high percentage impact on the price of a butterfly spread. Traders must, therefore, be disciplined in taking partial profits if possible and also in taking "small" losses before the losses become "big.
Long puts have negative deltas, and short puts have positive deltas. Regardless of time to expiration and regardless of stock price, the net delta of a butterfly spread remains close to zero until one or two days before expiration.
If the stock price is above the highest strike price in a short butterfly spread with puts, then the net delta is slightly positive. If the stock price is below the lowest strike price, then the net delta is slightly negative.
Overall, a short butterfly spread with puts profits from a stock price rise above the higher strike price or a fall below the lower strike price. Impact of change in volatility Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices.
Definition of 'Butterfly Spread Option'
As volatility rises, option prices tend to butterfly control on options if other factors such as stock price and time to expiration remain constant. Long options, therefore, rise in price and make money when volatility rises, and short options rise in price and lose money when volatility rises. When volatility falls, the opposite happens; long options lose money and short options make money.
Short butterfly spreads with puts have a positive vega. This means that the price of a short butterfly spread falls when volatility rises and the spread makes money.
This strategy is established for a net debit, and both the profit potential and risk are limited. Amazon Appstore is a trademark of Amazon. Open one today! Recommended for you. Source: nseindia.
When volatility falls, the price of a short butterfly spread rises and the spread loses money. Short butterfly spreads, therefore, should be established when volatility is "low" and forecast to rise.
BASIC Butterfly Spreads The good news is that investors can slightly tweak many option strategies, including the butterfly, to gain maximum control over the risk and reward By Michael Rechenthin The butterfly option strategy owes its popularity to its high reward-to-risk ratio, which might range from 4 to 1 to even 10 to 1. The relatively low risk and high profit potential for the butterfly make it tempting.
Impact of time The time value portion of an option's total price decreases as expiration approaches. This is known as time erosion.
Long option positions have negative theta, which means they lose money from time erosion, if other factors remain constant; and short options have positive theta, which means they make money from time erosion.
A short butterfly spread with puts has a net negative theta as long as the stock price is in a range between the lowest and highest strike prices. If the stock price moves out of this range, however, the theta becomes positive as expiration approaches.
Risk of early assignment Stock options in the United States can be exercised on any business day, and holders of short stock option positions have no control over when they will be required to fulfill the obligation.
Therefore, the risk of early assignment is a real risk that must be considered when entering into positions involving short options.
Advanced Option Trading: The Modified Butterfly Spread
While the long puts center strike price in a short butterfly spread have no risk of early assignment, the short puts do have such risk. Early assignment of stock options is generally related to dividends. Short puts that are assigned early are generally assigned on the ex-dividend date.
In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. If one short put is assigned most likely the highest-strike putthen shares of stock are purchased and the long puts center strike price and the other short put remain open.