BWB
Converting a butterfly into a BWB eliminates the debit. Continually paying for butterfly spreads can get expensive, especially when done over the course of a whole year. One way to reduce or eliminate the debit is to sell a vertical spread in conjunction with the butterfly. By adding the sale of a short vertical spread to the furthest away-from-the-money option, the complete package can be purchased for zero cost. This can pay for the debit butterfly spread and will create a Broken Wing Butterfly spread.
1-3-2
The 1-3-2 trade is created in the much same way; however, the sale of the spread is at higher strikes. Instead of the short vertical starting at the back of the butterfly, it will start in the middle. The option that was sold twice in a regular butterfly will now be sold three times and the back end of option will be purchased twice. This results in the ownership of a 1-3-2 spread.
The two boxes above are each divided into three columns. The first column in each box shows the traditional butterfly which costs $.24. The second column marked “addition” is the sale of a vertical spread. The third column labeled “final” is the resulting spread. Notice that the “addition” spreads that were sold are NOT the same. When creating the BWB spread, the 106/104 vertical put spread was sold for a $.27 credit and the resultant spread will give us a $.03 credit for all the pieces. These two spreads would be done as one package so we will avoid getting additional commissions on the 106 puts.
After starting out with the regular butterfly in the second box, we sold the 108/106 put vertical for a $.43 credit. When added to the cost of the regular butterfly, we have a total credit of $.19. Remember that these two spreads are usually done at the same time to avoid extra commissions. Now that we fully understand the difference in the creation of these two spreads, the rest of this session will deal with the two trades’ construction objectives, risks, and strengths.
CONSTRUCTION OBJECTIVES
BWB
* spread sold on back end of butterfly
* often looking for monthly profits
* possibly allowing wider distance between strikes
* can require stricter and quicker loss exit stops early in the monthly cycle
1-3-2
* spread sold within body of butterfly
* often looking for weekly profits
* pricing dictates smaller distances between strikes
* can try to hold until closer to expiration
With the short vertical spread being sold on the back end of the butterfly spread, it would then seem logical that our risk would start at that point and it does. In the above DJX put BWB spread, we own the 110/108/104 put package. In other words, we are long the 110 put, short two of the 108 puts, and then long the 104 put. Being long two puts and short two puts will result in a limited risk position.
The regular butterfly will not have any position risk, except for the cost of the position itself. However, we do not own the 106 puts with the BWB because they are part of the vertical put spread which we ‘synthetically’ sold when we did the position. Remember that we do this as a package to reduce commissions so we will not actually trade the 106 puts at all. Without ownership of the 106 puts, our risk will start there and go until the ownership of our next put. Since we own the 104 put in this case, our risk is between 106 and 104 – two points, or $200 per contract.
The breakeven point in this BWB spread is the start of our synthetic short. If we had the regular two point wide
butterfly, it would extend down from the 110 to the 106 level. Since we have no ownership of this 106 put, it will be the breakeven point of this BWB where the loss would start to occur at expiration. Graphically, it would look like the picture below:
We also sold a vertical put spread with the 1-3-2 put butterfly spread, but as noted above, it is within the body of the butterfly. We sold an extra 108/106 put vertical spread which “gave back” the profit we made from 110 to 108. Because it will start at a faster rate at 108, the breakeven point will be at a higher level than the BWB above. Note that the breakeven point on the 1-3-2 is at the 107 level at expiration; whereas on the BWB, it is at the105 level. As you construct these positions by placing your strike prices, this becomes an important consideration. Below is the graph of the 1-3-2 DJX butterfly:
As you can see from these graphs, the total risk for both of these spreads is $2.00 from a margin standpoint. We will also acknowledge the price differential of $.16 between the two spreads. The major differences are the expiration breakeven points and where the maximum loss starts to be incurred at expiration.
On the BWB, the breakeven is at $105.97 on the downside, while on the 1-3-2, the breakeven is at the $106.90 level. On the BWB, the maximum loss starts to be incurred at $104, while on the 1-3-2, the maximum loss starts to be incurred at $106. One trade is not necessarily better or worse than the other – they are just different.
The easiest way to understand many of the above risks and strengths associated with each trade is to observe the initial setup of the two types of trades. At the present time, weekly options are only traded on four index products: the SPX, XSP, OEX, and XEO.
There are actually very few XSP weekly options traded. So, although this could technically be a weekly index trade, it is more risky to enter and exit than we prefer because it has such a small open interest and daily volume at this time.
On the SPX, the primary challenge is the width between strikes where the weekly options are available. When the option chain is first listed with one week to go, the differential is 25 points between strikes. Unfortunately, this distance is not reduced until maybe one or two days before expiration. We feel this is too close to expiration, especially when using these options for weekly trades. Additionally, the BWB and the 1-3-2 trade will both be extremely expensive. It is very difficult to find any of these positions for even money. Most of them will be for debits.
One of the XSP’s challenges also arises when using the XEO options. The open interest and volume on this series of options is very low. Again, caution is advised. The OEX options are the most likely index option to use on a consistent basis for this 1-3-2 weekly trade. (Don’t forget that ANY option series, index, or equity can be used in the last week before expiration –they all become the equivalent of weekly options.)
Therefore, while the above four indexes exist and can be used for weekly 1-3-2 trade setups, the OEX will probably be used most frequently. We are merely stating our observations – they are certainly not company recommendations for or against any index. Therefore, let’s now discuss a number of the principal construction objectives, strengths, and risks using specific trades with the OEX index.
TRADE SETUP
1-3-2
Below are examples of trades which might be placed in a moderate VIX environment like the one we are in at this moment (VIX = 20.80).
With the OEX at 508 a weekly 1-3-2 OEX trade could be constructed in the following manner. First, let’s examine the expected move of the index over the its lifetime’s timeframe.
EM = stock price x vol x sq root of trading days/sq root 252
= $508 x .208 x sq root 5/252
= $508 x .208 x .141
= 14.9 points
Therefore, this equates to an expected move in the OEX from the present level of 508 up to 523, or down to approximately 493. These trades can be done using calls or puts to allow for both a bullish or bearish trade configuration. As a result of the skew in option prices between calls and puts, a call trade with an equal strike width and an equal distance out-of-the-money will typically be more expensive than a put setup of equal strikes.
These are the recent prices of options with the OEX closing around the 508 level. Don’t forget that we are looking at weekly option prices.
In this 1-3-2 trade, we placed our short options close to the expected move (thus making the 495 our short put options and the 520 our short call options). The cost for the trades would be a $.20 credit for the put position and a $.40 debit for the call trade.
We started with the first long option in the call and put setup trading at approximately 7 or 8 points out-of-the-money. As you can observe, the call trade with the same basic structure is an equal amount away from the underlying index value – but it is much more expensive than the comparable put position. This is caused by the option’s skew. While at-the-money call and put option prices can be comparable, the away-from-the-money put option prices continue to carry higher premium levels than the same away-from-the-money calls. Therefore, the call BWB and 1-3-2 trades will be more expensive than the equal put positions.
Using this expected move and construction setup in the strategic placement of our weekly butterfly allows us to straddle the probable movement on the index with the 500/495/490 strikes for our 1-3-2 spread. If you want to give the index more room to move (but with less probability of the index reaching the first long option), then you could use the 495/490/485 as our strike prices.
In either case, the setup of the 1-3-2 spread definitely considers the potential expected move over this rather short time period. One major benefit to this type of trade is that it could be used every week (four or five times a month) as a potential money making trade.
The risk in this trade is obviously the $5 points of margin that the strikes generate (less the $.20 credit) and the potential that the index will blow through all strikes to the downside in a very short timeframe. This is where trade management becomes a must. Traders should have a plan in place when initiating the position so they know how they will watch, adjust, or exit the position. As stated in many previous Webinar sessions, this is a personal choice, but it still must be established prior to entering the trade.
One of the primary benefits of the trade is that theta decay is very positive in the 1-3-2 trade setup. With the extra short 495/490 put vertical, the theta will probably remain positive until the last day (assuming no extraordinary decline). If and when the index falls to the 495 level, the primary risk in the position is the Delta and Gamma – and yet, this is precisely where we will make the most profit at expiration!
Thus, if your management style is to exit the position and the index ever gets down to the short strike price, you need to consistently follow your plan. If your style is to trade the position by value at all times, then this needs to be consistently followed. Whatever management style you choose, we feel consistency is important.
BWB
We will often initiate a broken wing butterfly three to six weeks prior to expiration. Our mindset is totally different than in the 1-3-2 trade discussed above. From a construction standpoint, we will start with the expected move at three weeks until expiration:
EM = stock price x vol x sq root of trading days/sq root 252
= $508 x .208 x sq root 15/252
= $508 x .208 x .244
= 25.8 points
Therefore, this equates to an expected move in the OEX from the present level of 508 up to 534, or down to approximately 482.
STRIKES PUTS
455 $0.65
460 $0.85
480 $1.95
490 $3.25
508 underlying
If we construct a BWB using the 490/480/460 puts, this position will cost us a $.20 debit. If we use the 490/480/455 strikes, we can do the trade for no cost.
The first trade will result in a margin of 10 points, or $1,000 per contract. The second trade using the 455 puts (instead of the 460 puts) will cost less, but the margin on the position will increase to $1,500.
Let’s discuss the new margin regulations on accounts under $125,000. The margin on the 490/480/460 BWB was $1,000, as stated. For smaller accounts, FINRA does not recognize the value of the long put spread (490/480) and requires full margin on the short 480/460 put vertical. Thus, the new margin requirements have doubled to $2,000 in the new regulatory environment. The new margin on the second 490/480/455 put BWB would be $2,500.
As you can see, the strike prices are typically placed much further out-of-the-money with longer timeframe spreads. This is to be expected since the index has a longer time to move before your options expire. It is also why the trade is structured to make as much as 10 points instead of just 5 points in the weekly trade setup in the OEX. There is no right or wrong strike price.
The movement of the index over the succeeding three weeks will determine which index should have been chosen. If the market rises, the second trade setup would have been better since no cost was put into the position. If the market drifts down, both trades may work equally as well since the 10 point vertical put spread (490/480) could expand nicely. If the market drops precipitously in a very short time, the short 480/455 spread could be more costly to buy back than the short 480/460 put spread. Index movement and time until expiration will be the deciding factors in the value of the position.
The theta decay is positive, and even with no movement in the index, the value of the trade will probably increase slightly over the next six to eight days. If the index does not start to make a movement in the direction of the 490 puts by the end of that time, the spread will begin to lose value and drift back to zero. Again, consistent management of the overall position needs to be practiced.
General Trading Observations/Conclusions
1-3-2
– They will tend to be done using weekly options instead of a three to five week period.
– Stick with your general guidelines for strike entry in normal volatility. If the volatility expands greatly, you can potentially choose wider spreads, or implement further-away-from-the-money options.
– Sometimes we will be looking for smaller overall dollar profits from one specific trade. Don’t forget that these profits can be made four or five times per month; therefore, we do not necessarily need to look for a huge dollar amount like we need on the BWB.
– This is similar to developing a business inventory for different amounts of profit margins. For instance, a grocery store is looking to turn its inventory over numerous times per month. Therefore, it will accept a lower profit margin than other businesses. A jewelry store knows it is only going to turn its inventory over one or two times per year; therefore, it must receive a much higher profit margin if it is to stay in business. The same is true on 1-3-2 weekly and BWB trades. Do not expect the two different dollar profits to be equal.
– When managing a position, consistency is very important. Develop profit goals or stop loss limits and stick to them. If your style is to hold all the way through expiration, be consistent. If your style is to exit expiration Friday, be consistent. Also if you no longer believe in your trade, exit the position. In other words, if you have a put 1-3-2 trade on with margin risk and you have turned extremely bearish, then don’t wait to exit the trade – do it now!
BWB
– These trades tend to be done for a three to five week period. Usually you will have to weigh the benefits of larger margin usage against the cost of the trade.
– Larger dollar profits can be made on the weekly trade setup. As a result of the large difference between the strikes, a larger profit can be made, but don’t get greedy and expect to make $10 on a $10 wide BWB. It will not usually happen. Any time 25 to 33 percent of the maximum profit value of the position can be made, you should closely evaluate whether you should exit or adjust the entire position.
– Managing the position usually won’t require the same amount of watching as the 1-3-2 trade because there is more time until expiration and larger distances between your long and short options. With this widening comes slower movement in the value of the spread. This does not mean you can place a BWB trade and then ignore it for days or weeks. Once the index starts to move in your desired direction (which is toward your first long option), you need to know the value of your options are to know if you should adjust or exit. These can be extremely profitable trades if the underlying drifts toward your short option strike. These can also present the most risk if there is very rapid movement towards your short options just after you put on the position. Whether or not you adjust or exit is always a judgment call.
These trades are both terrific uses of sophisticated option techniques. Consistency is the key to increasing a trader’s capital.
A terrific complete text on the 1-3-2 trade is now being written and is close to publication. Random Walk will notify everyone when it is available.