Butterfly: Part VI

This article is the final one in a series on the topic of Butterflies. It will recap the most important aspects of a butterfly and address the importance of understanding the interconnectedness of the Greeks.

Let me begin by stating the fact that option traders aren't limited only to bullish or bearish directions when trading the financial markets. It is true that the stock market can go three directions: up, down, or sideways. As a directional equity trader, one would have a hard time being profitable during a trendless market. But those are the times that give option traders the possibility of participation in a market place that is "confused" about its direction. In reality, a lot of the time the market goes sideways, anyways. In order to illustrate my point that the markets tend to trade sideways for prolonged periods of time, I have included the chart of the Dow Jones Industrials below, marking those sideways times. The blue boxes represent time when the Dow went sideways, the vertical lines also show the exact dates, while the bar counts represent how many months the market was just basically chopping around.

Besides showing the big picture view of the Dow that displayed months or even years of chop, I can also show a market that is currently fluctuating in a range and in reality going nowhere.

Once again, a sideways market is basically a range bound market such as the XLF as shown in Figure 2, which has been going nowhere for the last six months from August of 2009 to the present. During a range bound market neither the Bulls nor Bears have enough strength to break the extremes (support and resistance S/R).

During those times, there are two types of option strategies that I like to use when the market goes sideways. I have already written enough about Iron Condors, so this year I have focused on butterfly strategies.

The experienced option trader can be profitable during these times by applying the correct option strategy. In the case of XLF, an option trader could place a Butterfly with an aim of a specific price and quite a bit of time left for the target to get hit. The position will have negligible Greeks, as the Greeks would offset each other. How to manage a butterfly depends upon the option trader understanding the relationship between the Greeks.

Let me zoom in only on one of the Greeks: Theta. Theta is the amount of time erosion of an option's theoretical value over a single day. Theta (time decay) of long options is negative, meaning that for every single passing day whether calendar or trading day, the holder of long options is burning premium. Meanwhile the seller of options profits from time decay and the theta of sold options is positive.
Another significant point is that the at-the-money options have the highest theta. In the case of a butterfly, the long theta position is offset by the short theta position. Please refer to the article Butterfly: Part II to observe that the 41/43/45 call butterfly had a theta of only $4.91. On a butterfly the theta becomes progressively more positive when the underlying's price is approaching the middle strike (or sold strikes) also known as the Butterfly's body or guts. At the expiry, as the underlying is either at the specific price or approaching the middle strike (the body) the Greeks would be the following: short Gamma, short Vega, and positive Theta. If the underlying price is closer to the outer strikes (the wings) then the Greeks are exactly opposite: long Gamma and Vega, while the Theta is negative.

In conclusion, the greater the in depth understanding of the relationship between the Greeks that an option trader has, the better they will be able to manage the outcome of a butterfly trade. To learn more about the specifics of these Greeks and how they affect a butterfly, sign up for Online Trading Academy's Options Class. Have Green Trading.