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Last updated on February 10th, 2022 , 01:01 pm
Credit spread options strategies are insanely popular among income-driven traders, as the strategies have a high probability of profit and have limited loss potential.
But how do you select strike prices when trading credit spreads?
In this video, we’ll walk through a few methods you can use when selecting strike prices for your credit spread trades.
Last updated on April 8th, 2022 , 11:09 am
IMPORTANT! On March 14th, 2022, Barclays suspended the sale and future issuance of VXX.
VXX is wildly successful with millions of share/note volume each day and extremely active options contracts.
The original VXX reached its maturity in 2019, causing Barclays to launch VXXB (the same product with a different name). Barclays has since renamed VXXB back to VXX. Order is restored in the world.
To begin understanding what VXX is, let’s look at the product’s description:
VXX: The iPath® Series B S&P 500® VIX Short-Term FuturesTM ETNs (the “ETNs”) are designed to provide exposure to the S&P 500® VIX Short-Term FuturesTM Index Total Return (the “Index”).
You’ll notice that they call VXX the Series B ETN, which is referring to the fact that this is the second VXX product launched by Barclays due to the fact that the original VXX reached its maturity date on January 30th, 2019.
In order to understand exactly how VXX works, we need to understand the “S&P 500 VIX Short-Term Futures Index Total Return,” or the “Index.”
On the VXX Information Page, the S&P 500 VIX Short-Term Futures Index is described:
The Index is designed to provide access to equity market volatility through Cboe Volatility Index® (the “VIX Index”) futures.
The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects market participants’ views of the future direction of the VIX index at the time of expiration of the VIX futures contracts comprising the Index.
The VIX Index measures a constant 30-day weighting by using multiple SPX options expiration cycles. Since there isn’t an exact 30-day expiration cycle on every single trading day, Cboe uses the following methodology to calculate a constant 30-day implied volatility using SPX options:
“Only SPX options with more than 23 days and less than 37 days to the Friday SPX expiration are used to calculate the VIX Index. These SPX options are then weighted to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.” – Cboe
As mentioned earlier, VXX tracks the S&P 500 VIX Short-Term Futures Index, which tracks the first and second month VIX futures contracts:
The S&P 500® VIX Short-Term Futures Index utilizes prices of the next two near-term VIX® futures contracts to replicate a position that rolls the nearest month VIX futures to the next month on a daily basis in equal fractional amounts. This results in a constant one-month rolling long position in first and second month VIX futures contracts. (source)
VXX’s goal is to track the daily percentage change of a 30-day VIX futures contract. Since there isn’t a VIX futures contract with 30 days to settlement on each trading day, they use the first-month and second-month VIX futures to calculate a 30-day VIX futures contract from the weightings and prices of the futures that are actually trading.
As an example, consider the following VIX futures contracts:
First-Month VIX Future: 15 Days to Settlement / Current Price of 15
Second-Month VIX Future: 45 Days to Settlement / Current Price of 16
In this particular scenario, the S&P 500 VIX Short-Term Futures Index would use a 50% weighting in each VIX futures contract to come up with the 30-day VIX futures contract:
(15 Days x 50% Weighting) + (45 Days x 50% Weighting) = 7.5 + 22.5 = Weighted 30 Days to Settlement
The calculated price of the 30-day “synthetic” VIX futures contract would be 15.50:
(15 x 50% Weighting) + (16 x 50% Weighting) = 7.5 + 8.0 = 15.50.
VXX tracks the daily percentage change of this one-month VIX futures contract.
For instance, if this hypothetical one-month VIX futures contract went from 15.50 to 16.50 (+6.45%) on this particular trading day, VXX would increase by 6.45%.
On the other hand, if the one-month VIX futures contract went from 15.50 to 14.00 (-9.68%) on this particular trading day, VXX would decrease by 9.68%.
Please keep in mind that this is a hypothetical example, but it is conceptually accurately and describes how the one-month VIX future is calculated and where VXX’s returns come from on a daily basis.
VXX’s daily movements are based on the previous day’s closing price.
For instance, if VXX was $50 and the 30-day VIX future increased by 15% on one trading day, VXX would increase to $57.50. If, on the following trading day, the 30-day VIX future increased again by 15%, VXX would go from $57.50 to $66.13. Because of this, VXX can increase exponentially during multi-day streaks of VIX futures increases:
On February 19th, 2020, VXX closed at $13.56.
On March 12th, 2020, VXX closed at $47.36 (249% Increase):
Software: tastyworks
What drove these returns? The VIX futures, of course. Here are the VIX “term structures” or futures curves from February 19th, 2020 and March 12th, 2020 (courtesy of VIXCentral):
As we can see, the March and April VIX futures (the two left-most points on each line) increased substantially.
The March VIX future went from 15.38 to 58.30 during the timeframe (+279%).
The April VIX future went from 16.32 to 45.83 during the timeframe (+181%).
VXX went from $13.56 to $47.36 during the timeframe (+249%).
Notice VXX’s increase was within the range of increases of the March and April VIX futures.
The VXX increase was less than the 279% increase of the March VIX future, and more than the 181% increase of the April VIX future because at the beginning of the period, VXX’s weightings were mostly in the March future. As time passed, the weighting shifted out of the March VIX future and into the April VIX future.
The result is that VXX did not capture the 279% increase in the March VIX future, but did better than the 181% observed in the April VIX future.
To illustrate VXX’s movements relative to the VIX Index and near-term VIX futures, we plotted recent VXX price action against the VIX Index and futures:
Note: The chart says “VXXB” because the graph was made when VXXB was the ticker symbol for the current VXX. The data in the graph below is still accurate with the exception of the usage of “VXXB” instead of “VXX” as the ticker symbol.
In the above image, we’re looking at VXX (top line), the VIX Index (dashed line) and the first- and second-month VIX futures at the time (January 2019 and February 2019).
As we can see, the VIX Index increases significantly in the December 19 – 24 time period, which “pulls” the Jan/Feb VIX futures higher. It’s important to note that VXX’s increase is caused by the increase in the January and February VIX futures, not the VIX Index itself.
Also, the chart above only shows the price movements in points, not percentages. Over this period, VXX is tracking the daily percentage changes of the weighted 30-day VIX future, which is derived from the January and February VIX futures on each trading day.
Once the January VIX future settles, VXX’s movements will then be derived from the 30-day VIX future that is calculated from the February (first-month) and March (second-month) VIX futures.
The process repeats indefinitely over time.
The sections above outline the specific details of how VXX works. To explain everything concisely, remember the following about VXX:
1) VXX tracks the daily percentage change of a one-month VIX futures contract that is calculated using the first-month and second-month VIX futures contracts.
2) If the first-month and second-month VIX futures decrease, VXX will lose value.
3) If the first-month and second-month VIX futures increase, VXX will gain value.
4) Because of its VIX futures composition, contango causes VXX to decay in value greater than the VIX index.
It’s important to understand that from VXX’s inception date to maturity date, the product underwent numerous reverse splits to keep the product’s price from reaching $0.
Under “normal” market conditions, the VIX Index is typically below the near-term VIX futures contracts (a state of “contango”). As time passes, VIX futures contracts slowly converge towards the VIX Index. If the VIX Index is below the near-term VIX futures, the contracts will lose value over time, leading to losses in VXX.
Conversely, when the VIX Index is above the near-term VIX futures (a state of “backwardation”), the contracts will gain value over time, which leads to appreciation in VXX.
From VXX’s inception date (January 2009) to maturity date (January 2019), the product lost 99.99% of its value because the VIX futures are usually in contango.
Going forward, we should expect VXX to follow the same depreciation towards $0 over the long-term.
Hopefully, this post has helped you understand what VXX is and how it works on a daily basis.
For more information regarding VXX, refer to the following resources:
VIX is an index which does not offer shares.
VXX is an ETN which does offer shares.
VIX and VXX can vary widely in price because VXX performance is based on the daily percentage changes of short-term futures in multiple expirations. Read more about differences between these two products in our article, VIX vs VXX.
In the short-term, VXX can be a great hedge against S&P 500 stocks. However, over the long-run, VXX generally decays significantly in price due to the VIX futures being in contango a majority of the time.
VXX is not an ETF, but an ETN. ETN stands for exchange-traded note. ETN’s are instruments of debt, not equity (like ETFs).
The price of VXX is not necessarily calculated like the VIX Index because VXX shares fluctuate based on supply and demand.
However, the performance of VXX each day is based on the daily percentage change of a portfolio of near-term VIX futures with a 30-day weighted time to settlement. VXX share trading activity should keep the price of VXX in-line with this performance.
If VXX begins at $50 and the portfolio of near-term VIX futures rises 7% in a single trading day, VXX will increase to $53.50 ($50 x 1.07).
Last updated on February 10th, 2022 , 01:07 pm
The Iron Condor consists of the combination of two popular vertical spread strategies: the bull put spread and bear call spread. Specifically, this is the setup for selling an iron condor, which is the most popular way to trade the strategy.
Combining a bull put spread and a bear call spread results in a market-neutral position that profits when the stock price remains in-between the two spreads:
The above chart shows the expiration payoff for a hypothetical short Iron Condor position constructed with the following vertical spreads in the same expiration cycle:
Bull Put Spread
– Sell the 450 put for $10.00
– Buy the 400 put for $2.50
Bear Call Spread
– Sell the 550 call for $10.00
– Buy the 600 call for $2.50
Since $20.00 is collected for selling the 450 put and 550 call, and $5.00 is paid for purchasing the 400 put and 600 call, this Iron Condor example trade is said to be entered for a $15.00 net credit.
Maximum Profit Potential: Net Credit x 100
The maximum profit potential of one short Iron Condor is the net credit received, times 100, as standard equity options have a contract multiplier of 100 (such as options on AAPL, MSFT, SPY).
In the above example trade, the net credit is $15.00, which results in a maximum profit potential of $1,500 per Iron Condor sold:
$15.00 Net Credit x 100 = $1,500 Max Profit Potential.
The maximum profit potential is realized when the stock price is in-between the short put strike price and short call strike price at expiration. In this example, that’s anywhere between $450 and $550:
Maximum Loss Potential: (Width of Widest Spread – Net Credit) x 100
The maximum loss potential of selling one Iron Condor position is the strike price width of the wider vertical spread, less the net credit, times 100:
$50.00 Max Spread Width – $15.00 Net Credit x 100 = $3,500 Max Loss Potential.
Since only one of the spreads can be fully in-the-money at expiration, the width of the wider spread is the maximum value of the Iron Condor at expiration. In this example, both the call spread and put spread are $50 wide (400/450 put spread and 550/600 call spread).
If the Iron Condor is sold for $15.00, an increase to its maximum value of $50.00 would represent a loss of $3,500: ($15.00 Sale Price – $50.00 Maximum Trade Value) x 100 = -$3,500.
The maximum loss potential occurs if the stock price is entirely below the put spread OR entirely above the call spread at expiration:
While it may seem illogical to enter a trade with $1,500 in profit potential and $3,500 in loss potential, keep in mind that the stock price can increase or decrease up to 10% and the Iron Condor will realize the full $1,500 profit.
The only way the $3,500 max loss potential is realized is if the stock price is below $400 (the long put’s strike price) or above $600 (the long call’s strike price) at expiration. In other words, the stock price must increase/decrease by more than 20%.
Since the $1,500 profit is realized as long as the stock price remains within 10% of the $500 stock price at the time of entry, selling Iron Condors is a high probability trading strategy, meaning the probability of profiting on the trade is greater than 50%, in theory.
Selling Iron Condors is an extremely popular options trading approach for good reason. Here are the biggest benefits that make the strategy a crowd favorite:
✓ Limited-Risk Strategy – The loss potential is known before putting the trade on. No surprises.
✓ High Probability of Profit – The short Iron Condor makes the full profit when the stock price is in-between the two spreads at expiration, which means the stock price can be anywhere within the two spreads and the strategy will make money.
✓ Market-Neutral Strategy – Most trading strategies have a directional bias, meaning the stock price must move in a specific direction for the trade to profit. The short Iron Condor has no directional bias, as the trader just needs the stock price to remain within a certain range over time.
All strategies have risks. Here are the primary risks present when selling Iron Condors:
✓ More Risk Than Reward (Most Cases) – The high loss potential relative to the potential reward can be jarring for some, especially very risk-averse traders. However, it’s important to remember that the risk/reward relationship is a function of the strategy’s high probability of profit.
✓ Can Lose Money During Strong Bull Markets – Since selling Iron Condors is a market-neutral strategy, the trade loses money if the stock price increases significantly in a short period. During strong bull market periods, the short Iron Condor strategy will likely struggle to profit, which may deter traders who want bullish exposure to the stock market long-term.
✓ Early Assignment Risk – If the stock price falls well below the short put’s strike price or rises well above the short call’s strike price, the trader may be assigned on the short option that is in-the-money. While getting assigned doesn’t change the risk of the position or cause a large loss, it does turn the trade into a messy combination of options and shares of stock, which is an undesirable outcome for most.
If the stock price is in-between the two spreads, the options will all consist of 100% extrinsic value, which is lost over time as the options approach expiration.
If the stock price is fully beyond one of the spreads, the Iron Condor’s value will steadily appreciate to the value of the spread width as time passes. For instance, if the stock price is at $150 and a trader has an Iron Condor with the 140/145 short call spread ($5 spread width), the Iron Condor’s value will steadily appreciate to $5.00 as expiration approaches.
Implied volatility measures the amount of extrinsic value that exist in a stock’s options relative to the time until those options expire.
As an Iron Condor seller, the best-case scenario is that the options lose value over time and expire worthless.
Because of that, a decrease in implied volatility (a decrease in extrinsic value in the options) is beneficial to Iron Condor sellers, as a decrease in implied volatility indicates that the stock’s options have gotten cheaper through a decrease in extrinsic value.
A decrease in extrinsic value just means the market is expecting less volatility from the stock in the future, which results in less demand for the options and therefore a drop in the amount of extrinsic value the options have.
Conversely, an increase in implied volatility (an increase in extrinsic value in the options) is harmful to Iron Condor sellers, as an increase in implied volatility indicates that the stock’s options have gotten more expensive through an increase in extrinsic value.
An increase in extrinsic value just means the market is expecting more volatility from the stock in the future, which results in more demand for the options and therefore an increase in the amount of extrinsic value the options have.
Last updated on September 4th, 2024 , 12:46 pm
Just like stocks, you’ll need to open an account with a brokerage firm to be able to trade options. But how do you choose the best broker to open an account with?
Well, it depends on your needs and what you’re looking for in a brokerage firm. A good brokerage firm will provide traders with fast, intuitive and reliable technology, customer support, and low fees.
The preferred brokerage of projectoption is tastytrade. Most brokerage firms have a tiered privilege structure where you don’t get access to all options trading strategies such as shorting options, option spreads, etc. unless you’re in the highest tiers.
But with tastytrade, you get an all-inclusive margin account, meaning you get full privileges and access to all option trading strategies if you open an account with them. The all-inclusive account type is called “The Works,” which is their fully privileged margin account.
Above is an image of the tastytrade trading platform with the chart page opened up. I know it can be an intimidating thing to look at as a beginner, but there will be a learning curve with any platform you choose. It takes time to learn any new software.
So to familiarize you a little right now, let’s walk through different things that are shown in the image. On the left-hand side, there’s a watchlist for stocks/futures/indices you want to keep an eye on, and you can customize it as you wish.
The main panel depends on which stock you have selected at the time. In the above image, we can see that IWM is selected. On the top of the screen, it’ll show all the information about the bid price, ask price, volume, etc. We’ll discuss what these are later in the blog.
There are a couple more pages as well such as the Trade page which shows the option chain and all the expiration cycles of the options on the stock you’ve selected.
Every stock, future, ETF and option, all have a bid price and an ask price. The bid price basically means the highest price somebody is willing to pay for something.
In options trading, it is the highest order price for traders that are buying or the highest price a trader is willing to pay. This is the price you get when you sell an option/stock/future.
The ask price, on the other hand, is the lowest order price for traders that are selling, meaning the lowest price a trader is willing to sell something for. This is the price at which you buy an option.
And the difference between the bid and the ask price is called Bid-Ask spread. So for example, the bid price for an IWM share is $134 and the ask price for the same is $134.07, the difference of $0.07 between the two is the bid-ask spread.
This is important because the wider a bid-ask spread is, the more money you’ll lose from simply entering and exiting that trade. The technical term for this is “slippage.”
A thing to be noted is when trading options, you’ll be paying 100x the slippage since an option can only be converted into 100 shares of stock. For instance, if an option has a $0.05 bid/ask spread, then it technically means you’d lose $5 from buying at the ask and selling at the bid. If you buy an option at the asking price of $1.05 and sell it at the bid price of $1.00, you’ll lose $0.05 on the option trade, but that $0.05 actually represents a loss of $5.
Another term to know is “mid-price.” The mid-price is the midpoint between the bid and ask. Typically when you’re trading options, you’d want to try and fill your trades at or near the mid-price.
However, in most cases, you might not get filled on your trade at the mid price right away and therefore you might have to adjust your order to a slightly more unfavorable price.
Volume is the number of shares or contracts that have traded today. In tastytrade, we have two specific columns, one for volume and another for open interest.
Option volume is important to look at especially if you’re a beginner or buying an option on a stock you’ve never traded before.
Open interest is different from option volume. While option volume tells us the number of contracts traded today, option interest is the total number of open option contracts between two parties. If I buy 100 call options as an opening trade, and the counterparty sells those 100 contracts to me as an opening trade (they shorted the options), then open interest increases by 100.
If I sell 50 of those options (closing trade), and the counterparty buys 50 options as a closing trade as well, then open interest decreases by 50.
You don’t need to get caught up in the specifics, but higher open interest basically means there is more trading activity going on with those options, which is a good thing.
As you can see in the picture above, the open interest in IWM for the June 130 call option is 47.8k, while the option volume meaning options traded today are just 1.06K.
In a nutshell, open interest is the total number of contracts between all the traders in a particular option, and option volume is how many of those contracts traded today.
A thing to remember is that the stocks with high volume will have a narrower bid-ask spread as compared to those with low volume.
Now that you understand bid and ask price, and what option volume and open interest are, it’s time to finally see how you can buy different options or short them. For this example, we’ll perform all four basic trades in AMD.
So as you can see above, the bid and ask prices for the June 55 call in AMD right now are $3.00 and $3.10 respectively. When we try to buy an option, our goal will be to get it at mid-price which, in this case, that is $3.05.
All you have to do to place an order in tastytrade is click on the “ask price” of the option you’d like to buy and it’ll bring up an order to buy the option at the bottom of the screen, automatically at the mid-price.
As you can see below, when we clicked on the June 55 call option in AMD, it brought up the order window at the bottom of the screen. All you have to do now is click “Review & Send.”
When you “Review & Send” the order, it’ll show you another window that confirms all of the trade’s details for you, including the fees and change to your buying power, which is how much money you have available to allocate to trades.
The process for buying a put is exactly the same as buying calls, except instead of clicking on “ask price” on the left-hand side of the screen i.e. in the calls section, you do it in the puts section on the right-hand side. (See the image below to see how two sections are divided in tastytrade by the Strike column)
Shown: The option chain on tastytrade is divided into calls (left) and puts (right).
To short an option, meaning to sell an option that you don’t own (betting against the option price from increasing), click on the bid price for the specific option you want to short.
After clicking on the bid price, the order will merely be set up, but you won’t have shorted the option just yet. You’ll need to click Review & Send, and then confirm all the trade details.
After shorting one option, you will see a “-1” next to the option on the option chain, indicating you’ve shorted one of those options. On options you’ve purchased, there will be a positive number next to the option’s price on the option chain.
Shown: How it is indicated that you’ve purchased or shorted an option with the help of “1” & “-1” signs.
As you would have guessed by now, instead of clicking on the “bid price” on the call side of the screen, you click on “bid price” on the put side of the screen, just as we did at the time of buying puts and everything else remains exactly the same.
Closing an option refers to when you close your position and exit the trade by selling or buying back the option, making a profit or loss in the process.
There are two ways you can close an option. First, by directly right-clicking on the option in your positions tab and then clicking “Close Position,” as shown in the image below. Or you can do it manually from your main panel.
The way you do it manually is by executing the opposite trade of what you did earlier. So in the case of purchasing an option, you simply sell it to close the trade. And if you shorted an option, you buy it back to close the trade.
So if you buy an option as your opening trade, your closing trade is selling that same option.
If you short an option as your opening trade, your closing trade is buying back that same option.
The next step from here would be to learn more about options trading before you put lots of money into it. A great resource would be this blog along with our YouTube channel, which already has a lot of content and a family of hundreds of thousands of aspiring options traders, just like you. Be sure to check that out as well.
Last updated on February 10th, 2022 , 01:11 pm
Before you learn of shorting call and put options, you must first understand the basic components of these strategies. Let’s get started with learning about intrinsic and extrinsic value!
There are two components that make up the whole of an option’s price, known as Intrinsic & Extrinsic value. Let’s go through each of them one by one:
If you’ve gone through the first part of this guide, you don’t know it yet, but you already understand what an intrinsic value represents in an option’s price.
We had a house example in the first part where the house was valued at $350,000, and we had a call option to buy it at a strike price of $200,000. In that example, since we could buy the house $150,000 less than its current value (a benefit of $150,000), the call is said to have an intrinsic value of $150,000.
It means that the option contract in the home example is worth at least $150,000 because we, as the owner, can use it for a benefit or profit of $150,000.
For put options, it’s the opposite. If you have a put option with a strike price of $130 while the stock price is at $120, you have a put contract that can sell stock $10 higher than its current value, meaning a profit of $10. This $10 is called the intrinsic value of the option.
To sum up, intrinsic value is the real value that an option can provide to its owner, and it is the minimum value of an option contract.
The second component is called Extrinsic Value. An option’s extrinsic value is the portion of the option’s price that exceeds its intrinsic value. Let’s take an example to better understand it:
In the image above, TSLA is trading at a share price of $836.41 and we can see a call option with a strike price of $800. So as you can guess, the call option has an intrinsic value of $36.41, which is the benefit or real value it can provide to its owner. Why? Because the 800 call can be used to buy shares at $800/share, which is $36.41 below the current share price of $836.41.
But as we can see, the actual option price is $94.10, which is much higher than its intrinsic value. Here, the portion of the TSLA option’s price that is above its intrinsic value of $36.41 is called its extrinsic value.
We can understand an option’s extrinsic value as the part of its price associated with the potential for the option to become more valuable before its expiration. That is why the extrinsic value is sometimes referred to as “time value.”
As time passes, extrinsic value is lost, leaving only intrinsic value at expiration.
So in the case of this TSLA option, it has a 30-day expiration period. And going by TSLA’s volatility, we all know it can move around a lot in a 30-day period. So if TSLA ends up climbing to $900 by the option’s expiration date, its intrinsic value will increase to $100, which is why it makes sense that its current extrinsic value is $57.69.
This brings us to another point: options with a longer-term expiration date will trade with higher levels of extrinsic value compared to those with shorter expiration dates, because of the simple reason that with more time until expiry, stocks have larger potential movements.
These are the three terms that you’ll get to hear often as an options trader, that’s why it’s important to cover them before we get to shorting options.
These terms essentially describe whether or not an option has intrinsic value or not. They represent the “moneyness” of an option.
In-the-money means any option with intrinsic value. So in our TSLA example, if the call’s strike price is $800 while the stock price is $836, the call has an intrinsic value of $36. Therefore, the call is said to be “in-the-money.”
Out-of-the-money is the exact opposite. Any option is said to be out-of-the-money when it has a 100% extrinsic value or no intrinsic value.
An example could be the IWM put option with a put strike price of $130 and a stock price of $130.71. The put option doesn’t have any intrinsic value in its price and therefore it is said to be an out-of-the-money put option.
The last term is at-the-money, which is when an option has a strike price equal to or very close to the current stock price.
Shorting options can be confusing for beginners because here you’ll learn that we don’t always buy options, we can actually bet against them too. Betting against an option means that we put on a trade that profits when the option price falls.
If you know stock trading, then you probably know what shorting stocks is. It means that you sell the stock first at the current price without owning the shares, and then close your position by buying them back in the future, ideally at a lower price.
Shorting options is the same concept, but instead of stocks, you short options. You open your position by selling options you don’t own and your goal is to buy back the option at a lower price in the future.
So for example, say I short a call option for $5, meaning I collect a premium of $500 in my account, and later if the option price falls to $3, I buy back the option at a premium of $300, making a $200 profit on the trade.
Let’s take a real-life example of shorting a call option to get a complete understanding of the subject:
In the above image, we can see that the current share price of IWM is $120.59, and we look at shorting the June 125 call option (strike price of $125). The call option is 100% extrinsic value, meaning it is “out-of-the-money.” The option’s price is $4.66, which, again, is 100% extrinsic.
Now since we’re shorting options, I’ll not pay the $466 premium, rather I’ll collect it in my account, as we’re selling this option right now. But remember, collecting the money doesn’t mean it produces a profit. I’ll still have to buy it at a lower price to realize any profit.
Before we move forward, I must tell you that this is an extremely risky trade to enter. Because a call option’s price increases with the stock price, and since there’s no upper limit to how high a stock’s price can go, a call option also has no upper price limit. Therefore, “shorting a naked call option” like this trade has unlimited loss potential, in theory.
And since it is such a risky strategy, you’ll have to have a margin account. That means you have to be able to put collateral aside to enter the position. So the example that we’ve just seen above would require me to have $2,000 set aside in my account to bear potential losses if I want to short this call option.
Before we move forward, it is important to discuss the concept of the breakeven price and how it is possible to make money even if the stock price is above the call’s strike price. Say you short a call option in NFLX (Netflix) with a strike price of $400 and short it for $17 (you collect $1,700).
The breakeven price for this call trade is $417. But why? Because at expiration, an option will only have intrinsic value, if any. For a call option with a strike price of $400, the call will have $17 of intrinsic value if the stock price is at $417. If the stock price is at $417 at expiration, the call will be worth $17 (premium of $1,700). Since that’s the same as my initial sale price, I’d have no profit or loss if the option was worth $17 at expiration.
And so if NFLX is below $417 at expiration, the call will be worth less than the initial sale price of $17, and the short call position will profit.
That is how it is possible to make a profit on a short call even if the stock price is higher than the call’s strike price at the expiration date.
Thus far, we’ve talked about buying call options, buying put options, and shorting call options. Finally, we’ll be talking about shorting put options.
Similar to shorting call options, you sell the put option first and then buy it later at a lower premium (hopefully). As we know, put option prices decrease when the stock price increases, which means betting against a put option would mean betting in a stock price increase.
This is why shorting put options is a bullish trade: you profit when the stock rises and face losses when it falls.
For this example, we’ll look at a put option in Activision (ATVI). On the left-hand side of the chart below, ATVI is trading at $67 per share. So let’s say I’m a trader who wants to profit from the increase in ATVI but at the same time, I’m not super sure that the stock price will increase.
In this case, shorting put option will be one available options trade for me. And so I decide to short the May 65 put option at a premium of $175, which I collect when entering the trade. I need to buy back the put for less than $175 to make a profit.
In the left-hand chart, we can see that the stock price increased significantly by the expiration date of the put, and the put option price (right-hand chart) sank to just $0.02. This means that the option that I sold earlier at a premium of $175, I can now buy it at a premium of $2, making a profit of $173.
So that wraps it up for this part. Up until now, we’ve talked about four basic option trades: buying calls, buying puts, shorting calls and shorting puts. These four trades will make up any options trading strategy that you’ll ever see in the future. We also discussed how option prices work and the price components, and also went over terms such as In-the-money, out-of-the-money, and at-the-money.
Last updated on February 10th, 2022 , 01:16 pm
The long iron butterfly options strategy consists of simultaneously buying a call option and a put option at the same strike price (a long straddle), and selling an out-of-the-money call and out-of-the-money put (a short strangle).
All options must be in the same expiration cycle.
A long iron butterfly position can be conceptualized in two ways:
1) Simultaneously buying a straddle and selling a strangle (as described above).
2) Simultaneously buying a call spread and put spread with the purchased options having the same strike price.
TAKEAWAYS
The long iron fly strategy is very similar to a long straddle, except a long iron fly has less risk because the options that are sold reduce the entry cost of the position.
Let’s go over the strategy’s general characteristics:
➥Max Profit Potential: (Strike Width of Widest Spread – Debit Paid) x 100
➥Max Loss Potential: Debit Paid x 100
➥Expiration Breakeven:
Upper Breakeven = Long Strike + Debit Paid
Lower Breakeven = Long Strike – Debit Paid
➥Estimated Probability of Profit: Less than 50% because the stock price must move significantly in either direction and/or implied volatility must increase for profits to occur.
To explain these characteristics in more detail, let’s look at a basic example:
In the following example, we’ll construct a long iron butterfly from the following option chain:
In this case, we’ll buy the 300 call and 300 put for a total debit of $24.25, and we’ll sell the 250 put and 350 call for a total credit of $1.31. Let’s also assume the stock price is trading for $300 when we put this trade on:
Initial Stock Price: $300
Short Strikes: $250 short put, $350 short call
Long Strikes: $300 long put, $300 long call
Credit Received for Short Options: $1.31
Debit Paid for Long Options: $24.25
Total Debit Paid: $24.25 Debit – $1.31 Credit = $22.94
The following visual describes the position’s potential profits and losses at expiration:
As we can see here, a long butterfly’s profit potential lies well outside of the long strike price. In this example, the stock price must move ±$22.94 just for the position to break even and ±$50 to reach maximum profit at expiration.
As a result, the position has a low probability of profit, which is also supported by the fact that the profit potential is greater than the loss potential.
The table below explains the performance of this position based on various scenarios at expiration:
Stock Price Below the Short Put Strike ($250) -OR- Above the Short Call Strike ($350):
One of the spreads of the long iron butterfly expires fully in-the-money. With spreads strikes that are $50 wide, the iron fly would be worth $50. Due to an initial purchase price of $22.94, the long iron butterfly trader realizes the maximum profit of $2,706: ($50 iron fly expiration value – $22.94 purchase price) x 100 = +$2,706.
Stock Price Between the Short Put Strike ($250) and the Lower Breakeven Price ($277.06):
The long 300 put is worth more than the $22.94 the iron fly was purchased for, and therefore the iron fly position is profitable at expiration. All other options expire worthless.
Stock Price Between the Lower Breakeven Price ($277.06) and the Long Put Strike ($300):
The long 300 put has intrinsic value, but not more than the $22.94 that was paid for the iron butterfly. Because of this, the position is not profitable (or breaks even if the stock price is exactly $277.06). All other options expire worthless.
Stock Price At the Long Strike ($300):
All of the iron butterfly’s options expire worthless, resulting in the maximum loss of $2,294. This scenario is extremely unlikely because it only occurs at one specific price.
Stock Price Between the Long Call Strike ($300) and the Upper Breakeven Price ($322.94):
The long 300 call has intrinsic value, but not more than the $22.94 the iron fly was purchased for. Because of this, the position is not profitable (or breaks even if the stock price is exactly $322.94). All other options expire worthless.
Stock Price Between the Upper Breakeven Price ($322.94) and the Short Call Strike ($350):
The long 300 call has more intrinsic value than the $22.94 paid for the iron fly. Because of this, the position is profitable.
So, you know how the outcomes at expiration when buying iron flies, but what about before expiration? Understanding how profits and losses occur can be explained by the position’s option Greeks (if you want to improve your understanding of the risks your option positions carry, read our ultimate guides on the option Greeks).
You’ve learned the general characteristics of the long iron fly strategy. Next, we’re going to visualize the performance of the strategy over time by looking at some trade examples.
In this section, we’re going to visualize the performance of some long iron fly positions that recently traded. Note that we don’t specify the underlying, since the same concepts apply to long iron flies on any stock.
Additionally, each example demonstrates the performance of a single iron fly position. When trading more contracts, the profits and losses in each case will be magnified by the number of iron flies traded.
Let’s do it!
The first example we’ll look at is a scenario where a trader buys an iron fly, but the stock price is near one of the breakeven prices at expiration.
Initial Stock Price: $105.79
Strikes and Expiration: Long 106 Call and Put; Short 97 Put and 112 Call; All options expiring in 45 days
Premium Paid for Long Options: $3.04 for the 106 put + $2.50 for the 106 call = $5.54 in premium paid
Premium Collected From Short Options: $0.77 for the 97 put + $0.35 for the 112 call = $1.12 in premium collected
Net Debit: $5.54 in premium paid – $1.12 in premium collected = $4.42 net debit
Breakeven Prices: $101.58 and $110.42 ($106 – $4.42 and $106 + $4.42)
Maximum Profit Potential (Upside): ($6-wide call spread – $4.42 debit) x 100 = $158
Maximum Profit Potential (Downside): ($9-wide put spread – $4.42 debit) x 100 = $458
Maximum Loss Potential: $4.42 debit x 100 = $442
As mentioned earlier, the maximum profit potential of a long iron butterfly depends on the wider spread. In this example, the long call spread is $6 wide, and the long put spread is $9 wide. Because of this, the maximum profit potential of this iron fly occurs when the stock price collapses through the long put spread. More specifically, this trade has $158 in profit potential on the upside and $458 in potential profits on the downside, resulting in a bearish bias.
Let’s see what happens!
As you can see, the long iron fly position does not perform well because the stock price does not rise fast enough over the period. At expiration, the stock price is just above the upper breakeven price of the position, resulting in minimal profits.
At expiration, the trader would end up with +100 shares of stock because the long 106 call is in-the-money. If the trader wanted to avoid a stock position, they would have to sell the 106 call before expiration.
In the following example, we’ll investigate a situation where the stock price rises continuosly and is above the long call strike price at expiration.
Here are the specifics:
Initial Stock Price: $74.44
Strikes and Expiration: Long 75 Put and Call; Short 70 Put and 80 Call; All options expiring in 39 days
Premium Paid for Long Options: $2.80 for the 75 put + $2.29 for the 75 call = $5.09 in premium paid
Premium Collected for Short Options: $0.95 for the 70 put + $0.67 for the 80 call = $1.62 in premium collected
Net Debit: $5.09 in premium paid – $1.62 in premium collected = $3.47 net debit
Breakeven Prices: $71.53 and $78.47 ($75 – $3.47 and $75 + $3.47)
Maximum Profit Potential: ($5-wide spreads – $3.47 net debit) x 100 = $153
Maximum Loss Potential: $3.47 net debit x 100 = $347
In this example, both the long call spread and long put spread are $5 wide, so the profit potential is equal on both sides of the trade. Let’s take a look at what happens!
In this example, the long iron fly performs well because the stock price rises through the long call spread in a timely manner. At expiration, the long 75/80 call spread is entirely in-the-money, resulting in an expiration value of $5. The long put spread expires worthless, but it doesn’t matter. With an initial purchase price of $3.47, the $5 value of the iron fly’s call spread at expiration results in the maximum profit of $153: ($5 iron fly expiration value – $3.47 purchase price) x 100 = +$153.
In the final example, we’ll examine the worst-case scenario for a long iron fly, which is when the stock price expires near the long strike. Here’s the setup:
Initial Stock Price: $752
Strikes and Expiration: Long 750 put and call; Short 625 Put and 875 Call; All options expiring in 46 days
Premium Paid for Long Options: $36.25 for the 750 put + $37.30 for the 750 call = $73.55 in premium paid
Premium Collected for Short Options: $4.50 for the 625 put + $2.90 for the 875 call = $7.40 in premium collected
Net Debit: $73.55 in premium paid – $7.40 in premium collected = $66.15 net debit
Breakeven Prices: $683.85 and $816.15 ($750 – $66.15 and $750 + $66.15)
Maximum Profit Potential: ($125-wide spreads – $66.15 net debit) x 100 = $5,885
Maximum Loss Potential: $66.15 debit x 100 = $6,615
In this example, both spreads have equal strike widths, so the profit potential is the same on both sides. Let’s see what happens!
As we can see here, the iron fly in this example did not do well because the stock price remained between the breakeven points as time passed. At expiration, the stock price was trading for $737.60, which means the long 750 put was only worth $12.40 while all of the other options expired worthless. Consequently, the iron fly’s expiration value consists of the long 750 put’s value of $12.40. With an initial purchase price of $66.15, the iron fly buyer realizes a loss of $5,375: ($12.40 iron fly expiration value – $66.15 purchase price) x 100 = -$5,375.
Since the long put is in-the-money at expiration, the trader would end up with -100 shares of stock if the put was held through expiration. To avoid a share assignment, the long 750 put would need to be sold before expiration.
Last updated on February 10th, 2022 , 01:18 pm
The long straddle is an option strategy that consists of buying a call and put on a stock with the same strike price and expiration date. Since the purchase of an at-the-money call is a bullish strategy, and buying a put is a bearish strategy, combining the two into a long straddle technically results in a directionally neutral position. However, a long straddle requires a significant shift in the stock price to profit, though the direction doesn’t matter. Because of this, a buying straddles is essentially a long or positive gamma strategy.
When buying straddles, profits come from large movements in the stock price or increases in implied volatility, as long as too much time doesn’t pass before either of those events happen.
TAKEAWAYS
Let’s go over the long straddle strategy’s general characteristics:
➥Max Profit Potential: Unlimited
➥Max Loss Potential: Net Debit x 100
➥Expiration Breakeven
Upper Breakeven = Strike Price + Debit Paid
Lower Breakeven = Strike Price – Debit Paid
To demonstrate these characteristics in action, let’s take a look at a basic example.
In the following example, we’ll construct a long straddle from the following option chain:
In this case, we’ll buy the 250 call and 250 put. Let’s also assume the stock price is $250 when entering the trade.
Initial Stock Price: $250
Long Strikes Used: 250 put, 250 call
250 Put Purchase Price: $15.10
250 Call Purchase Price: $15.20
Total Debit Paid: $15.10 + $15.20 = $30.30
The following visual describes the potential profits and losses at expiration when buying this particular straddle:
As illustrated here, a long straddle realizes the maximum loss potential when the stock price is trading exactly at the long strike at expiration. Because of this, achieving maximum loss on a long straddle is very unlikely. Regarding profits, we can see that a large movement in the stock price is required for the straddle to be profitable at expiration. In this example, the stock price has to move ±12% in either direction just to break even, which makes buying straddles a low probability trade.
The table below explains the performance of this position based on various scenarios at expiration:
Stock Price Below the Lower Breakeven Price ($219.70)
The 250 call expires worthless but the long 250 put has more intrinsic value than the entire straddle was purchased for ($30.30), and therefore the straddle buyer realizes profits.
Stock Price Between the Lower Breakeven and the Long 250 Put ($219.70 to $249.99)
The 250 call expires worthless. The 250 put has intrinsic value, but not more than the premium the trader paid when buying the straddle. Consequently, the long straddle position is not profitable.
Stock Price Exactly at $250
Both the 250 call and 250 put expire worthless. The long straddle trader ends up with the maximum loss potential.
Stock Price Between the Long Call Strike and the Upper Breakeven ($250.01 to $280.30)
The 250 put expires worthless. The 250 call has intrinsic value, but not more than the premium the trader paid when buying the straddle. Consequently, the long straddle position is not profitable.
Stock Price Above the Upper Breakeven ($280)
The 250 put expires worthless but the 250 call has more intrinsic value than the straddle was bought for, and therefore the long straddle position is profitable. Since the stock price can rise indefinitely, the long call (and consequently the entire long straddle) has unlimited profit potential.
So, you know how the potential outcomes at expiration, but what about before expiration? Understanding how profits and losses occur when buying straddles can be explained by the position’s option Greeks (if you want to improve your understanding of option risks, read our ultimate guides on the option Greeks).
The option Greeks describe the various risks of an option position. In the following table, we’ll discuss the general Greek exposures of a long straddle position.
Delta: Generally speaking, a long straddle’s position delta will start near zero if the trader buys an at-the-money straddle (e.g. a -50 delta long put and a +50 delta long call). However, as the stock price changes, a long straddle will take on a positive or negative delta position.
Gamma: Positive – When the stock price rises, a long straddle becomes directionally long because the delta of the long call becomes more significant while the delta of the long put diminishes. On the other hand, when the stock price falls, a long straddle becomes directionally short because the delta of the long put becomes more significant while the delta of the long call diminishes. The concept of positive gamma will be discussed further in the example trades.
Theta: Negative – The extrinsic value of options decays as time passes, which is harmful to straddle buyers.
Vega: Positive – An increase in implied volatility suggests an increase in option prices, which is excellent for straddle buyers. On the other hand, a decrease in implied volatility suggests falling option prices, which is detrimental to straddle buyers.
When buying straddles, the main profit drivers are increases in implied volatility and large stock price changes.
As time passes, the extrinsic value of options decays away, leading to losses for option buyers. Consequently, to be profitable when buying straddles, large stock price movements or increases in implied volatility must occur in short periods of time.
Nice job! Next, we’ll go through some visualized trade examples to observe the performance of long straddles through time.
In this section, we’re going to visualize the performance of long straddles relative to changes in the stock price. Note that we don’t specify the underlying, since the same concepts apply to long straddles on any stock.
Additionally, each example demonstrates the performance of a single position. When trading more contracts, the profits and losses in each case would be magnified by the number of straddles traded.
Let’s do it!
The first example we’ll look at is a situation where the stock price trades in a tight range after an at-the-money straddle is purchased.
Here are the trade details:
Initial Stock Price: $210.72
Initial Implied Volatility: 15%
Strikes and Expiration: 211 put and 211 call expiring in 77 days
Straddle Purchase Price: $5.46 for the put and $4.32 for the call = $9.78 total debit paid
Breakeven Prices: $201.22 and $220.78 ($211 – $9.78 and $211 + $9.78)
Maximum Profit Potential: Unlimited
Maximum Loss Potential: $9.78 total debit x 100 = $978
Let’s see what happens!
As you can see, buying straddles is not profitable when the stock price doesn’t rise or fall quickly with magnitude. In this case, the stock price traded near the long strike the entire time, leading to losses from time decay. Additionally, implied volatility remained around 15% the entire period, so profits from an implied volatility increase didn’t occur.
In this example, the straddle price continously fell. To lock in the profits or losses on a long straddle position, the long options can be simultaneously sold at their current prices. For example, if the trader in this position sold the straddle for $4.00, they would have locked in a $578 loss: ($4.00 sale price – $9.78 purchase price) x 100 = -$578.
At expiration, the stock price was above $211, which means the long call was in-the-money and the long put was out-of-the-money. However, the long 211 call only had $1.50 of intrinsic value at expiration, which results in a $828 loss for the straddle buyer: ($1.50 straddle value at expiration – $9.78 initial purchase price) x 100 = -$828.
At expiration, the trader would end up with +100 shares of stock if the in-the-money 211 call was held through expiration. To avoid a stock position, the call would need to be sold before expiration.
The example above demonstrates what can go wrong when buying straddles. In the next demonstration, we’ll look at a scenario where a long straddle position turns into a big winner.
In the next example, we’ll look at how a long straddle performs when the stock price falls significantly. In particular, we’ll examine a long straddle position on a stock in late 2008.
Here are the trade details:
Initial Stock Price: $126.20
Initial Implied Volatility: 23%
Strikes and Expiration: 126 put and 126 call expiring in 78 days
Straddle Purchase Price: $5.18 for the put + $5.07 for the call = $10.25 total debit paid
Breakeven Prices: $115.75 and $136.25 ($126 – $10.25 and $126 + $10.25)
Maximum Profit Potential: Unlimited
Maximum Loss Potential: $10.25 debit x 100 = $1,025
Let’s see how the trade performed:
As you can see here, the long straddle position performed poorly in the first 40 days of the period. However, the stock price suddenly collapsed from $125 to $95. At the same time, implied volatility in the expiration cycle of the long straddle spiked to over 75%. Consequently, the price of the 126 straddle surged in price to $35. With an initial purchase price near $10, the profit is $2,500 per long straddle when the straddle is worth $35: ($35 straddle price – $10 purchase price x 100) = +$2,500.
If the trader wanted to take profits before expiration, the straddle can be sold at its current price. For example, if the straddle was sold for $25, the trader would have locked in $1,475 in profits: ($25 sale price – $10.25 initial purchase price) x 100 = +$1,475.
At expiration, the stock price was $31 below the straddle’s strike price of $126, which translates to $31 of intrinsic value for the 126 put and $0 of intrinsic value for the 126 call. Because of this, the expiration profit for the straddle buyer is $2,075: ($31 expiration straddle value – $10.25 initial purchase price) x 100 = +$2,075.
If held through expiration, the long 126 put would become -100 shares of stock. So, if the trader wanted to avoid a stock position, the long 126 put would need to be sold before expiration.
In addition to demonstrating the potential profits from buying straddles, this example serves as an excellent demonstration of how a straddle’s delta can change rather quickly. As mentioned earlier, a long straddle position has positive gamma, which means that as the stock price trends in one direction, the delta (directional exposure) of the position will grow in the same direction. For example, if the stock price increases, the delta of a long straddle position will become more positive, resulting in a bullish position. Conversely, when the stock price decreases, the delta of a long straddle position will grow more negative, resulting in a bearish position.
Let’s visualize the concept of positive gamma using the same example as above:
As visualized here, the position delta of the long straddle moves with the stock price. When the stock price increases, the position delta becomes more positive, which means the position is more bullish. When the stock price decreases, the position delta becomes more negative, which means the position is more bearish. Intuitively, this should make sense because the profit potential of a long straddle occurs when the stock price changes significantly in one direction.
Therefore:
➜ When the stock price falls below the strike price, the position becomes bearish because the ideal scenario is for the stock price to continue falling.
➜ When the stock price rises above the strike price, the position becomes bullish because the best case scenario is for the stock price to fall to continue rising.
In this example, the delta of the long straddle turned negative when the stock price fell. As a result, further stock price decreases lead to profits for the straddle buyer, explaining why a long straddle benefits from continued stock price movements in one direction.
Lastly, at expiration, the straddle’s position delta is -100. Since an in-the-money long put expires to -100 shares of stock, the position delta of -100 makes sense.
In the final example, we’ll look at an example where a straddle buyer doesn’t make or lose much money.
In the final example, we’ll look at a scenario where a long straddle trader doesn’t make or lose much money, which occurs when the stock price is near one of the straddle’s breakeven prices at expiration.
Here are the trade details:
Initial Stock Price: $210.56
Strikes and Expiration: 211 put and 211 call expiring in 60 days
Straddle Purchase Price: $4.83 for the put + $3.51 for the call = $8.34 total debit paid
Breakeven Prices: $202.66 and $219.34 ($211 – $8.34 and $211 + $8.34)
Maximum Profit Potential: Unlimited
Maximum Loss Potential: $8.34 net debit x 100 = $834
Let’s see what happens!
As we can see here, the stock price fell significantly after the long straddle was entered. As a result, the position had profits over the entire period. At the highest point, the profit on the long straddle was approximately $1,700: ($25 straddle price – $8.34 purchase price) x 100 = +$1,666.
However, the stock price rallied back to the long straddle’s lower breakeven and the trade had a small loss at expiration. The only way the trader could have secured the profits on the position would have been to sell the straddle while it was profitable.
At expiration, since the long 211 put was in-the-money, the trader would end up with -100 shares of stock if the put was held through expiration. If the trader wanted to avoid a stock position, the long 211 put would need to be sold before it expired.
Congratulations! You should now be much more confident with how the long straddle works as a trading strategy!
Let’s review what we have learned:
Last updated on February 10th, 2022 , 01:21 pm
The long strangle is an options strategy that consists of buying an out-of-the-money call and put on a stock in the same expiration cycle.
Since the purchase of a call is a bullish strategy and buying a put is a bearish strategy, combining the two into a strangle results in a directionally neutral position.
However, even though a strangle is not directionally specific (bullish or bearish), the strategy requires a significant stock price change in either direction or an increase in implied volatility to profit. In other words, buying a strangle is bullish AND bearish.
If a large stock price movement or increase in implied volatility does not occur, the position’s value will slowly decrease, leading to losses for the strangle buyer.
TAKEAWAYS
Let’s look at the long strangle’s general characteristics:
Max Profit Potential: Unlimited
Max Loss Potential: Debit Paid x 100
Expiration Breakeven
Upper Breakeven = Call Strike Price + Total Debit Paid
Lower Breakeven = Put Strike Price – Total Debit Paid
Estimated Probability of Profit:
Less than 50% because a significant stock price change or an increase in implied volatility is required to profit.
To explain these characteristics further, let’s look at a basic example.
In the following example, we’ll construct a long strangle position using the following option chain:
In this case, we’ll buy the 190 put and the 210 call. Let’s also assume the stock price is trading for $200 when the strangle is purchased.
Initial Stock Price: $200
Long Strikes/Purchased Options Used: 190 put, 210 call
190 Put Purchase Price: $3.78
210 Call Purchase Price: $4.31
Total Debit Paid: $3.78 + $4.31 = $8.09
The following visual describes the potential profits and losses of this position at expiration:
As illustrated in this visual, a long strangle has significant profit potential when the stock price makes a large move in either direction. However, the low risk and high reward nature of a long strangle suggests that such a movement is not probable. In this particular example, the stock price must move ±18.09 for the position to break even at expiration, which represents nearly a 20% move in either direction.
In this section, we’re going to visualize the performance of real long strangles that recently traded in the market. Note that we don’t specify the underlying, since the same concepts apply to long strangles on any stock. Additionally, each example demonstrates the performance of a single strangle position. When trading more contracts, the profits and losses in each case would be magnified by the number of strangles traded.
Let’s do it!
The first example we’ll look at is a situation where a hypothetical trader buys a strangle with a call and put that have deltas near ±0.20. With a delta near ±0.20, the call and put both have an estimated 20% probability of expiring in-the-money, respectively.
Because of this, the strangle as a whole has an approximate 40% probability of expiring in-the-money, which translates to a 60% probability of expiring out-of-the-money (max loss for the strangle buyer).
Here are the trade details:
Initial Stock Price: $212.44
Initial Implied Volatility: 14%
Strikes and Expiration: 201 put and 219 call expiring in 63 days
Strangle Purchase Price: $1.75 for the put and $0.83 for the call = $2.58 total debit
Breakeven Prices: $198.42 and $221.58 ($201 – $2.58 and $219 + $2.58)
Maximum Profit Potential: Unlimited
Maximum Loss Potential: $2.58 net debit x 100 = $258
Let’s see how this trade performed:
In this example, we can see that the price of the 201/219 strangle decays continously over time because the stock price remains between the long strikes. Additionally, implied volatility remained flat because the stock price did not move violently in either direction. At expiration, both options expire worthless, resulting in the maximum loss potential of $258 for the strangle buyer.
If the trader wanted to lock in losses at any point, they could have sold the strangle at its current price. For example, if the trader sold the strangle for $1.50, they would have locked in a loss of $108: ($1.50 sale price – $2.58 purchase price) x 100 = -$108.
In this example, we’ll examine the performance of a long strangle when the stock price collapses through the long put strike.
Here are the trade details:
Initial Stock Price: $524
Initial Implied Volatility: 26%
Strikes and Expiration: 495 put and 555 call expiring in 39 days
Strangle Purchase Price: $6.35 for the put and $6.20 for the call = $12.55 total debit paid
Breakeven Prices: $482.45 and $567.55 ($495 – $12.55 and $555 + $12.55)
Maximum Profit Potential: Unlimited
Maximum Loss Potential: $12.55 net debit x 100 = $1,255
Let’s see how the trade performed:
This time around, we can see that when the stock price falls significantly, the price of the strangle surges because the price of the long put explodes. Additionally, when the stock price falls significantly, implied volatility tends to spike, which indicates higher option prices across the board.
At the highest point, the 495/555 strangle is worth $43.85, which represents a profit of $3,130: ($43.85 strangle price – $12.55 purchase price) x 100 = +$3,130. Unfortunately, the stock price rallied back and the strangle ended up expiring worthless, but this example still demonstrates how a significant move in the stock price leads to profits for a strangle buyer.
Congratulations! You should now be much more comfortable with how buying strangles works as an options trading strategy.
Let’s review what we have learned:
Last updated on February 14th, 2022 , 09:52 am
The long butterfly spread is a limited-risk, neutral options strategy that consists of simultaneously buying a call (put) spread and selling a call (put) spread that share the same short strike price. All options are in the same expiration cycle. Additionally, the distance between the short strike and long strikes is equal for standard butterflies.
Butterflies are used when a trader believes the stock price will trade near a certain price in the future, as a butterfly’s maximum profit potential occurs when the stock price trades at the position’s short strike at expiration. Regarding losses, butterflies usually have very low risk because they are cheap, which is represented by the fact that they generally have a low probability of profit. However, butterflies can carry more risk when wider strikes are used.
Lastly, butterflies can be constructed with all calls or puts without changing the risk-reward profile of the position. For example, both of the following long butterfly positions will have the same potential profits and losses:
Call Butterfly:
Long 100/105 Call Spread; Short 105/110 Call Spread (Buy 1x 100 Call, Sell 2x 105 Calls, Buy 1x 110 Call)
Put Butterfly:
Short 100/105 Put Spread; Long 105/110 Put Spread (Buy 1x 100 Put, Sell 2x 105 Puts, Buy 1x 110 Put)
TAKEAWAYS
Let’s go over the strategy’s general characteristics:
➥Max Profit Potential:
Long Call Butterfly: (Width of Long Call Spread – Debit Paid) x 100
Long Put Butterfly: (Width of Long Put Spread – Debit Paid) x 100
➥Max Loss Potential: Debit Paid x 100
➥Expiration Breakevens:
➣Upper Breakeven
Long Call Butterfly: Short Strike + (Width of Long Call Spread – Debit Paid)
Long Put Butterfly: Higher Long Put Strike – Debit Paid
➣Lower Breakeven
Long Call Butterfly: Lower Long Call Strike + Debit Paid
Long Put Butterfly: Short Strike – (Width of Long Put Spread – Debit Paid)
➥Position After Expiration
If the call or put butterfly is entirely in-the-money at expiration, the exercise and assignments will offset since there are an equal number of long and short options.
If the butterfly is partially in-the-money, the trader will end up with a stock position at expiration.
1 Long Call In-the-Money: +100 shares of stock
1 Long Call and 2 Short Calls In-the-Money: -100 shares of stock
Here are the resulting stock positions for a partially in-the-money put butterfly at expiration:
1 Long Put In-the-Money: -100 shares of stock
1 Long Put and 2 Short Puts In-the-Money: +100 shares of stock
To demonstrate these characteristics in action, let’s take a look at a basic butterfly example.
In the following example, we’ll construct a long call butterfly from the following option chain:
To construct a long call butterfly, we’ll have to buy a call spread and sell a call spread that share the same short strike. In other words, we’ll buy one call, sell two calls at a higher strike price, and purchase one call at an even higher strike price.
In this case, we’ll buy the 250 call, sell two of the 300 calls, and buy one of the 350 calls. Let’s also assume the stock price is trading for $300 when we put this trade on:
Initial Stock Price: $300
Short Strike: $300 short call (x2)
Long Strikes: $250 long call, $350 long call
Credit Received for Short Calls: $12.14 x 2 = $24.28
Debit Paid for Long Calls: $50.42 + $0.92 = $51.34
Total Price Paid: $51.34 paid – $24.28 received = $27.06
Before we move on, you’ll notice that the put butterfly using the same strike prices has the same cost:
Long 350 put for $50.89 + Long 250 put for $0.39 = $51.28 debit
Short two 300 puts: $12.11 x 2 = $24.22 credit
Net Debit: $51.28 debit – $24.22 credit = $27.06
Since both the call and put butterfly have the same price and strike widths, they have the same maximum loss potential. Additionally, since they have the same strike widths, they must also have the same profit potential. So, put and call butterflies are identical. For the remainder of this guide, we’ll just use long call butterflies in the examples to keep things simple.
Moving our focus back to the long call butterfly example, the following visual describes the position’s potential profits and losses at expiration:
As illustrated above, the long call butterfly achieves maximum profit when the stock price is trading at the short strike at expiration, which is a very low probability event. So, making full profit on a long butterfly position should not be expected. With that said, there’s still plenty of profit potential if the stock price is trading somewhere near the short strike at expiration.
Regarding loss potential, the butterfly in this example has a maximum loss potential of $2,706, which is the debit paid x 100. Maximum loss occurs when the stock price is above or below one of the long call strikes at expiration.
Great job! You’ve learned the general characteristics of the long butterfly strategy. Now, let’s go through some visual trade examples to see how the strategy performs through time.
To visualize the performance of the long call butterfly strategy relative to the stock price, let’s look at a few examples of some options that recently traded. Note that we don’t specify the underlying because butterfly concepts are transferrable to other stocks in the market. Additionally, each example demonstrates the performance of a single position. When trading more contracts, the profits and losses in each case will be magnified by the number of butterflies traded.
Let’s do it!
The first example we’ll look at is a scenario where a trader buys a butterfly, but the stock price is near one of the breakevens at expiration.
Here are the trade details:
Initial Stock Price: $105.79
Strikes and Expiration: Short two 106 calls; Long 98 call and 114 call; All options expiring in 45 days
Premium Collected for Short Calls: $2.50 x 2 = $5.00 in premium collected
Premium Paid for Long Calls: $8.46 for the 98 call + $0.14 for the 114 call = $8.60 in premium paid
Net Debit: $8.60 in premium paid – $5.00 in premium collected = $3.60 net debit
Breakeven Prices
Lower Breakeven: $98 long call strike + $3.60 debit paid = $101.60
Upper Breakeven: $106 short strike + ($8-wide call spread – $3.60 debit) = $110.40
Maximum Profit Potential: ($8-wide long call spread – $3.60 debit paid) x 100 = $440
Maximum Loss Potential: $3.60 debit x 100 = $360
Let’s see how the trade performed:
As illustrated here, the 98/106/114 long call butterfly performed well over most of the period because the stock price was relatively close to the short strike, resulting in profits from time decay.
If the trader wanted to lock in profits, they could have sold the butterfly at its price at any point in the trade. If the trader sold the butterfly for $4.50, they would have locked in a profit of $90: ($4.50 sale price – $3.60 initial purchase price) x 100 = +$90.
Unfortunately, the stock price was above the upper breakeven price at expiration and the call butterfly suffered a very small loss.
Regarding a share assignment, this particular trader would have been assigned -100 shares of stock if they did not close one of the in-the-money short calls before expiration. Closing one of the in-the-money short calls would leave the trader with one in-the-money long and short call, which would offset in terms of exercise and assignment. Either way, there’s always a chance that the trader is assigned early on the in-the-money short calls before expiration.
Next, we’ll take a look at a scenario where a butterfly realizes the maximum potential loss.
In the following example, we’ll investigate a situation where the stock price rises continuosly and is above the higher long call strike price of a butterfly at expiration.
Here are the trade details:
Initial Stock Price: $74.44
Strikes and Expiration: Short two 75 calls; Long 70 call and 80 call; All options expiring in 67 days
Premium Collected for Short Calls: $3.10 x 2 = $6.20 in premium collected
Premium Paid for Long Calls: $6.15 for the 70 call + $1.28 for the 80 call = $7.43 in premium paid
Net Debit: $7.43 in premium paid – $6.20 in premium collected = $1.23 net debit
Breakeven Prices
Lower Breakeven: $70 long call strike + $1.23 debit paid = $71.23
Upper Breakeven: $75 short strike + ($5-wide call spread – $1.23 debit) = $78.77
Maximum Profit Potential: ($5-wide long call spread – $1.23 debit paid) x 100 = $377
Maximum Loss Potential: $1.23 debit x 100 = $123
Let’s take a look at what happens:
As we can see here, the long call butterfly did not do well because the stock price increased significantly over the trade period. At expiration, the call butterfly was fully in-the-money. Consequently, the buyer of the call butterfly realized the maximum loss potential since the butterfly wasn’t worth anything at expiration.
Regarding a share assignment, all of the in-the-money calls would offset at expiration. However, there’s a chance that the trader in this example is assigned early on the two in-the-money short calls before expiration.
In the final example, we’ll look at a scenario where a long butterfly trader makes almost full profit at expiration.
Here are the trade details:
Initial Stock Price: $752
Strikes and Expiration: Short two 750 calls; Long 700 call and 800 call; All options expiring in 46 days
Premium Collected for Short Calls: $37.30 x 2 = $74.60 in premium collected
Premium Paid for Long Calls: $68.40 for the 700 call + $16.75 for the 800 call = $85.15 in premium paid
Net Debit: $85.15 in premium paid – $74.60 in premium collected = $10.55 net debit
Breakeven Prices
Lower Breakeven: $700 long call strike + $10.55 debit paid = $710.55
Upper Breakeven: $750 short strike + ($50-wide call spread – $10.55 debit) = $789.45
Maximum Profit Potential: ($50-wide long call spread – $10.55 debit) x 100 = $3,945
Maximum Loss Potential: $10.55 debit x 100 = $1,055
Let’s see what happens!
In this example, the 700/750/800 long call butterfly performed very well because the stock price was near the short strike at expiration.
More specifically, the stock price was trading for $737.60 at expiration, resulting in an expiration value of $37.60 for the 700/750/800 call butterfly (since the 700 call expired worth its intrinsic value of $37.60 and the other calls expired worthless).
Since the initial purchase price was $10.55, the expiration profit would be $2,705: ($37.60 expiration value – $10.55 purchase price) x 100 = +$2,705.
At expiration, this position would expire to +100 shares of stock since only the 700 call expired in-the-money. If the trader did not want to be long shares after expiration, the long 700 call would need to be sold before expiration.
Congratulations! You should now feel much more comfortable with how the long butterfly works as a trading strategy. Let’s recap what we learned:
Last updated on February 10th, 2022 , 01:25 pm
A short iron butterfly position can be conceptualized in two ways:
1) Simultaneously selling a straddle and buying a strangle.
2) Simultaneously selling a call spread and put spread with the same short strike price.
The iron fly strategy is very similar to a short straddle, except an iron fly has less risk due to using spreads as opposed to naked short options.
TAKEAWAYS
➥Max Profit Potential: Net Credit Received x 100
➥Max Loss Potential: (Strike Width of Widest Spread – Net Credit Received) x 100
➥Expiration Breakevens:
Upper Breakeven = Short Strike + Net Credit Received
Lower Breakeven = Short Strike – Net Credit Received
To demonstrate these characteristics in action, let’s take a look at a basic example and visualize the iron butterfly strategy’s potential profits and losses at expiration.
In the following example, we’ll construct a short iron butterfly from the following option chain:
In this case, we’ll sell the 300 call and 300 put for a total credit of $24.25, and we’ll buy the 250 put and 350 call for a total debit of $1.31. Let’s also assume the stock price is trading for $300 when we put this trade on:
Initial Stock Price: $300
Short Strikes: $300 short put, $300 short call
Long Strikes: $250 long put, $350 long call
Credit Received for Short Options: $12.14 + $12.11 = $24.25
Debit Paid for Long Options: $0.39 + $0.92 = $1.31
Total Credit Received: $24.25 Credit – $1.31 Debit = $22.94
The following visual describes the position’s potential profits and losses at expiration:
As illustrated above, the short iron butterfly strategy realizes its maximum profit potential when the stock price is trading at the short strike at expiration, which has a low probability of occurring. However, since the short iron butterfly can collect a lot of premium, making partial profits on a short iron butterfly still results in healthy profits compared to making full profit on strategies that collect less premium (such as a short strangle).
Additionally, you’ll notice that a short iron butterfly has a similar risk profile to a short straddle, except the risk of a short iron butterfly is limited beyond the long options.
Regarding loss potential, both the short call spread and put spread are $50 wide. Because of this, the maximum potential loss is: ($50 strike width – $22.94 credit received) x 100 = $2,706. However, if the call spread were $75 wide (e.g. 300 short call and 375 long call), the maximum loss potential of this iron fly would be: ($75 strike width – $22.94 credit received) x 100 = $5,206. So, the loss potential of a short iron fly always depends on the width of the wider spread.
When each spread has the same width, the risk of loss is equal on both sides.
Nice job! You’ve learned the general characteristics of the short iron fly strategy. Now, let’s go through some visual trade examples to solidify your knowledge of how selling an iron butterfly works in practice.
To visualize the performance of the iron fly strategy relative to the stock price, let’s look at a few examples of some iron butterflies that recently traded. Note that we don’t specify the underlying, since the same concepts apply to short iron flies on any stock. Additionally, each example demonstrates the performance of a single iron fly position. When trading more contracts, the profits and losses in each case will be magnified by the number of iron flies traded.
Let’s do it!
The first example we’ll look at is a scenario where a trader sells an iron fly, but the stock price is near one of the breakeven prices at expiration.
Here are the trade details:
Initial Stock Price: $105.79
Strikes and Expiration: Short 106 Call and Put; Long 97 Put and 112 Call; All options expiring in 45 days
Premium Collected for Short Options: $3.04 for the 106 put + $2.50 for the 106 call = $5.54 in premium collected
Premium Paid for Long Options: $0.77 for the 97 put + $0.35 for the 112 call = $1.12 in premium paid
Net Credit: $5.54 in premium collected – $1.12 in premium paid = $4.42 net credit
Breakeven Prices: $101.58 and $110.42 ($106 – $4.42 and $106 + $4.42)
Maximum Profit Potential: $4.42 net credit x 100 = $442
Maximum Loss Potential (Upside): ($6-wide call spread – $4.42 net credit) x 100 = $158
Maximum Loss Potential (Downside): ($9-wide put spread – $4.42 net credit) x 100 = $458
As mentioned earlier, the maximum loss potential of an iron fly depends on the wider spread. In this example, the short call spread is $6 wide, and the short put spread is $9 wide. Because of this, the maximum loss potential of this iron fly occurs when the stock price collapses through the short put spread. More specifically, this trade has $158 in loss potential on the upside and $458 in potential losses on the downside. Consequently, this particular short iron fly position has a slightly bullish bias because the trader would prefer the stock to rise instead of fall (if the stock was to move in one direction at all).
Let’s see what happens!
As we can see, this short iron fly was profitable almost the entire period because the stock price was between the breakeven prices. As the days passed, the 106 call and put decayed in price more than the long 97 put and 112 call. Because of this, the position was profitable. However in the final days before expiration, the stock price rallied above the upper breakeven price of $110.42, leading to losses on the position.
More specifically, the stock price was trading for $110.64 at expiration, which means the loss on the iron fly was only $22: ($110.42 upper breakeven – $110.64 final stock price) x 100 = -$22. The strategy is a net loser because the 106 short call expires with $4.64 of intrinsic value when $4.42 was collected for selling the iron fly. Since the position is worth more than it was sold for initially, the trader incurs losses.
In this example, the position was profitable for most of the period, which means the position could have been closed for a profit. If the trader wanted to lock in profits before expiration, an iron fly could be closed by purchasing the short call and put, and selling the long call and put.
Regarding a share assignment, this particular trader would be assigned -100 shares of stock if they did not close the in-the-money short call before expiration. If the trader did not want a short stock position, the short call would need to be bought back before expiration. However, there’s always a chance that the trader could get assigned early on the short call.
Ok, so you’ve seen a short iron fly that breaks even. Next, we’ll take a look at a scenario where a short iron fly realizes the maximum potential loss.
In the following example, we’ll investigate a situation where the stock price rises continuosly and is above the long call strike price at expiration.
Here are the trade details:
Initial Stock Price: $74.44
Strikes and Expiration: Short 75 Put and Call; Long 70 Put and 80 Call; All options expiring in 39 days
Premium Collected for Short Options: $2.80 for the 75 put + $2.29 for the 75 call = $5.09 in premium collected
Premium Paid for Long Options: $0.95 for the 70 put + $0.67 for the 80 call = $1.62 in premium paid
Net Credit: $5.09 in premium collected – $1.62 in premium paid = $3.47 net credit
Breakeven Prices: $71.53 and $78.47 ($75 – $3.47 and $75 + $3.47)
Maximum Profit Potential: $3.47 net credit x 100 = $347
Maximum Loss Potential: ($5-wide spreads – $3.47 net credit) x 100 = $153
In this example, both the short call spread and short put spread are $5 wide, so the risk is equal on both sides of the trade.
Let’s take a look at what goes wrong:
As we can see in this example, the stock price rallied from $74.44 to over $82.50 during the life of this short iron fly position. With an upper breakeven of $78.47, this iron fly suffered losses. However, with a $5-wide short call spread, the maximum value of this iron fly is $5, which caps the iron fly seller’s losses to $153 since the iron fly was sold for $3.47: ($3.47 sale price – $5 expiration value) x 100 = -$153.
At expiration, an in-the-money short call expires to -100 shares of stock and an in-the-money long call expires to +100 shares of stock. Consequently, there is no resulting stock position for the iron fly seller in this example.
In the final example, we’ll look at a scenario where a short iron fly trader makes almost full profit at expiration. The maximum profit of an iron fly occurs when the stock price is at the short strike at expiration.
Here are the trade details:
Initial Stock Price: $752
Strikes and Expiration: Short 750 put and call; Long 625 Put and 875 Call; All options expiring in 46 days
Premium Collected for Short Options: $36.25 for the 750 put + $37.30 for the 750 call = $73.55 in premium collected
Premium Paid for Long Options: $4.50 for the 625 put + $2.90 for the 875 call = $7.40 in premium paid
Net Credit: $73.55 in premium collected – $7.40 in premium paid = $66.15 net credit
Breakeven Prices: $683.85 and $816.15 ($750 – $66.15 and $750 + $66.15)
Maximum Profit Potential: $66.15 net credit x 100 = $6,615
Maximum Loss Potential: ($125-wide spreads – $66.15 net credit) x 100 = $5,885
In this example, both spreads have equal strike widths, so the risk is the same on both sides. Note that since the maximum profit potential of this trade is greater than the maximum loss potential, this particular iron fly has less than a 50% probability of profit, in theory. Additionally, the at-the-money straddle is trading for $73.55, indicating an “expected move” of around $75, while the iron fly only collects only $66.15. So, if the stock price shifted by the expected move, the position would be a loser because the stock price would be beyond one of the breakeven points.
Let’s see what happens that allows this trade to make money!
In this example, the short 750 iron fly did quite well because the stock price remained between the breakeven prices for most of the period. Additionally, the stock price was trading for $737.50, just $12.50 below the iron fly’s short strike. Because of this, the 750 put expired with intrinsic value of $12.50 while all of the other options expired worthless. As a result, the net value of the iron fly at expiration is just $12.50. With an initial sale price of $66.15, the profit for the iron fly seller is $5,365: ($66.15 initial sale price – $12.50 expiration value) x 100 = +$5,365.
Regarding a share position, the short iron fly trader would be assigned +100 shares of stock if the short 750 put was held through expiration. Assuming the trader isn’t assigned early on the short put before expiration, the trader could avoid a share assignment by purchasing the short 750 put right before expiration.
Congratulations! You should now feel a lot more comfortable with the short iron butterfly strategy! Let’s review what we have learned:
