The Butterfly

This is a strategy I have not employed heretofore, and here is why: Essentially, a butterfly is a strategy where you buy 1 wing at a lower price, sell 2 wings at a higher price, and buy 1 wing at a higher price still. Here, I will analyze a butterfly on Apple Computer (AAPL), which closed Friday 1/18/13 at $500. It looks like this:

     Buy 1 call option of AAPL at 490
     Sell 2 call options of AAPL at 500
     Buy 1 call option of AAPL at 510

As you can see from the above, I have constructed this butterfly with all call options. Butterflies can also be constructed wtih put options, and can also be reversed, as in Sell 1/Buy 2/Sell 1.  Here, I will discuss the above (Buy 1/Sell 2/Buy 1 calls).  Please note that butterflies are typically done on the same stock, with the same expiration date.

The "best" (or most potentially lucrative) butterflies are those that cost little relative to the potential profit. This butterfly is a debit butterfly, and the prices as of 1/21/13 are:
   

Buy 1 AAPL Feb13 490 Call	$27.45	$2,745.00
Sell -2 AAPL Feb13 500 Call	$22.35	($4,470.00)
Buy 1 AAPL Feb13 510 Call	$17.90	$1,790.00

TOTAL COST (DEBIT) $65

I am doing a single contract. As you can see, your total out of pocket cost for this position is $65, including commissions (at OptionsXpress).

What is the expectation? That AAPL close exactly at $500 to reap the greatest profit of $935. These are terrific risk:reward numbers - spend $65 to potentially make $935. But ... and this is a pretty big but, stocks have a mind of their own, and rarely close precisely at a selected price. Thus, it is mandatory to manage the spread.

In the example above, what you want to do is close your short (sell) position as quickly as possible. You've sold 2 contracts of the $500 calls for $22.35 each, and you would want to buy them back much more cheaply as soon as possible. For the $500 call to decrease in value, AAPL would have to decrease in price. That is a rather big risk, given that it is already about $200 from its high, and is probably oversold at this point. If the stock rallies hugely upward, your 490-500 bull call spread will be profitable, but will be mitigated by your 500-510 bear call spread. Therefore, what you want to do is buy to close (BTC) the bull spread as soon as it reaches close to its maximum (in this example, $10, or $1000, because each contract controls 100 shares).  Since AAPL is coming up for earnings on 1/23/13, this might be a cheap way of straddling the stock. No matter what happens with earnings, the most you could lose is $65.  If the stock crashes, you could buy back the short calls for relatively little money, and wait to see if the stock rebounds. 

But I would like to see how this strategy works with puts. With the same price points, a long (debit) put butterfly looks like this:

Buy 1 AAPL Feb13 490 Put	$19.10	$1,910.00
Sell -2 AAPL Feb13 500 Put	$24.00	($4,800.00)
Buy 1 AAPL Feb13 510 Put	$29.75	$2,975.00

TOTAL COST (DEBIT) $85

The difference is that if AAPL rallies with good earnings, your short puts can be bought more cheaply to close that position, letting your long 490 and 510 puts remain open to capture decreases in price, if those happen.

I am still not happy with this trade, because the options premiums for both calls and puts are extremely high, dollar-wise. Let's see what happens if I make this into a short (credit) put butterfly: The short butterfly, however, brings in a credit of $55 for the risk of losing $945. Clearly, not good.

I welcome your comments.