Is my understanding of Butterflys correct

[CXMelga 0]

Hello,

I am trying to understand the different 'strategies' at the moment, some are easy to understand others are not, can you please tell me if I have the following correct

 

Short v Long butter fly

A Short butterfly (e.g. selling the ATM strikes and buying the other strikes, results in a credit to the writer)
  2 ATM strikes  + ITM strike + 1 OTM strike

  if price of underlaying does not more much on a Short butterfly the buyer will win and the writer will lose

 

A Long butterfly (e.g. buying ATM strikes and selling the other strikes, result debit to the writer)
  2 ATM strikes + 1 ITM strike + 1 OTM strike

  If the price of the underlaying does not move much on a long butterfly buyer loses and write wins

 

 

 

I have seen the above explained (or at least I think that is what they were trying to explain

I have also seen it explained where there are 'no' ITM strikes

 

Therefore the first thing I wanted to understand is does a butterfly spread consist of any ITM strikes or not ?

 

From the perspective of a options writer

Should both a short and long butterfly be used when IV is high or only to long butterfly when IV is high and the short butterfly when IV is low ?

 

Thanks very much in advance

CXMelga

 

 

 

[CXMelga 0]

Typo above, I meant to say 

underlaying does not 'move' much

[Kim 7,513]

The terminology is the opposite.

 

Buy long fly means selling ATM options and buying OTM and ITM options. And you want the underlying NOT to move.

buy short fly is the opposite.

 

Its counterintuitive but this is the terminology used.

[cuegis 683]

10 hours ago, Kim said:

The terminology is the opposite.

 

Buy long fly means selling ATM options and buying OTM and ITM options. And you want the underlying NOT to move.

buy short fly is the opposite.

 

Its counterintuitive but this is the terminology used.

You are correct.

I remember as a beginner on the floor, back in the 80's, being taught the definition of a butterfly, as the terminology was used in that environment, and the way it was first told to me was......"just think of it like this,....whatever you are doing to the "wings" (outer strikes) is what you are doing to the butterfly.....so if you are buying the wings, then you are buying the butterfly, and vice versa"

 

That was how it was accepted by brokers when receiving an order to fill......"buy a 68-70-72 fly meant buying 68 and 72 etc.

Investopedia even uses the same terminology.........https://www.investopedia.com/terms/b/butterflyspread.asp

 

In recent years, in the retail environment, I have seen that the opposite definition is used with the logic being that "whatever you are doing to premium ( credit or debit) is what you are doing to the fly"

So, if you are receiving a credit (selling the middle), you are selling the fly..

So, in the year 2018 I don't know what definition to use!

[CXMelga 0]

Thanks very much Kim and Cuegis, for taking the time to reply, I really appreciate it.  The original terminology from the 80's is easier to remember (what ever ou are doing with the wings you are doing to the fly). At least I know now there are two terminologies and using the above can understand it much better.

The next thing I have to do is get a piece of pen and paper and get my  little pee brain around how they fly is supposed to make you a profit (from a sellers perspective),

My initial thought is from a sellers (writer) perspective, if you are selling the middle and buying the cheaper outers, (no matter if all calls or all puts) therein getting a credit. You want no movement (or very little indeed) in the spot price (underlaying),  then you want Vega (volatility) to go down and down so the extrinsic value of the option drops and drops so you can buy back at a lower prise to make a profit (or let expire), is that right ?

If my thinking about is correct, it would therefore seem logical to sell a butterfly when IV is high and premiums are over stated and buy a butterfly when IV is low and premium is cheap ?

Thanks again all, I really do appreciate your time, I want to understand before I start to put up my hard earned cash in options 

Cheers

CXMelga

 

 

 

[Yowster 8,029]

30 minutes ago, CXMelga said:

if you are selling the middle and buying the cheaper outers

Correction here.. flys use all puts or all calls, so with the outer wings one will be cheaper than the middle and one will be more expensive.    With the official SO trades, we are always selling the middle although sometimes we use different widths for the wings - since they are vega negative (meaning they increase in value when IV drops) the trades are usually opened with IV is elevated.

[CXMelga 0]

Thanks very much Yowster, I am starting to get it ( a bit like learning to drive a car I am still in first gear at the moment and not left my driveway, but I will get there)

 

Thanks very muchCXMelga

 

 

[cuegis 683]

39 minutes ago, Yowster said:

Correction here.. flys use all puts or all calls, so with the outer wings one will be cheaper than the middle and one will be more expensive.    With the official SO trades, we are always selling the middle although sometimes we use different widths for the wings - since they are vega negative (meaning they increase in value when IV drops) the trades are usually opened with IV is elevated.

You left out the "Iron" fly, which is a straddle/strangle, using both puts and calls so, by definition, the outer strikes will always be less than the middle strikes. (OTM calls above and puts below).

That was sort of the go to, standard fly that was used during my years on the floor.

 

Also, whether buying or selling a fly was the most profitable choice at any given time had less to do with "theory" and everything to do with "pricing".

Neither buying, nor selling, a fly is a "better" strategy than the other.

It is all about the pricing of that fly .

 

In all of my years on the floor, the single most profitable trade, for everyone, at that point in time, was selling ATM fly's for 30% of the distance between strikes.

This was in crude oil mostly,( but pretty much in everything at that time), which at that time was moving through 2-3 strikes, several times a day, everyday.

We would buy the ATM straddle, and sell the next higher call, and lower put, and pay 30% debit of the distance between strikes.

For example, with crude at $70, we would buy the $70 straddle, and sell the $69 put, and $71 call, for a debit of .30 for a $1.00 wide fly.

Unlike stock options, which are x100 (shares), crude options are x1000 (barrels), so .30 = $300 (not $30).

As the price moved away from ATM ($70), the fly would immediately gain in value, and when it reached the next strike, would be priced at .60-.70 ( 100%+ gain).

Crude would travel past 2-3 strikes, back and forth several times a day.

 

So, buying the middle, and selling the wings "can" be the most profitable strategy there is IF the "pricing" favors it.

Our rule of thumb, which I would still use today, is to be able to sell a fly for 30% of the distance between strikes.

Given my history with this, I am always looking for this opportunity, which pretty much never exists in stocks, but does in various commodities from time to time.

This was a trade, like any other trade in history, that was discovered by a few people, and worked 100% of the time.

Then, as more and more people became aware of it, and more people used it, the pricing obviously would change, ultimately pricing itself out of having an edge.

 

But, because there was no retail access to this at that time, or personal computer trading platforms, this opportunity lasted 2-3 years before becoming too crowded and pricing itself out of profitability.

 

So no strategy is "better" than another ...what makes one the best opportunity is the "pricing" of that strategy.

And if a particular position becomes too popular, and therefore too "crowded", by definition the reverse has to be the best approach, because of the imbalance of liquidity.

Prices follow the "path of least resistance", and if most participants have a position on the same way, they will eventually need someone to be there to take the other side when they try to exit the trade.

 

This is why , more often than not, movement occurs that does not make "logical" sense.

There is tremendous opportunity in being "contrarian" when used properly, for these reasons.

 

These trade cycles are as old as the markets themselves... there is nothing new here, just the way it plays itself out in different situations, during different times.

Edited November 4, 2018 by cuegis

[cuegis 683]

Just another, sort of funny addition to this story, which illustrates what I was saying.....

Years later, after there were no longer anymore "floors" or floor trading, as everything converted to electronic trading, and retail trading platforms, out of curiousity I looked up crude oil iron fly prices just to see if the opportunity might still be there

What I found was that , if you wanted to buy the ATM straddle and sell the next strike ($1.00 wide) wings, as I described above, the price was now an .80 debit ( out of a $1.00 wide fly), much more than the opposite pricing that was originally there in it's infancy days.

 

This is what I was referring to about "pricing" being the factor of whether a strategy is a good opportunity, and not "theory".

At these prices, now the reverse position (buying the fly) would be a far better choice.

 

But, there is never just "free money" to be had....if there is an optimal "pricing" then there must be some reason for it.

Yes, the pricing would make that an ideal position but the catch is that a long fly will only perform best if price is stable....

Crude is probably the least stable underlying available, hence the pricing.

[CXMelga 0]

Hello Cuegis,

Thank you for taking the time to write up such a comprehensive reply, this really helps me learn

Yes, I am learning when selling options in particular is it all about the premium (and POP) because  an options writer you could be correct 80% of the time and still loose money if the credit on the trade was too low as the loses on the 20% that went against you would wipe out all the profit (even if only ever doing defined risk strategies) 

From what I understand at the moment the higher the IV the more expensive the options (for obvious reasons), and this pricing tends to be overstated when IV is very high (as implied volatility is almost always higher then actual volatility)

 

Thanks again

CXMelga

[Kim 7,513]

Here you go - Butterfly Spread - The Basics

[CXMelga 0]

Thanks Kim