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CXMelga

basic question about a butterfly

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Hello All

Can someone help me cement my understanding of the Butterfly, (I think I got it from previous information, but just need clarification please)

if I am in the business of selling options, than I believe I should be selling butterfly when IV is high meaning premiums are also likely to be high.

If that is the case, then if I sell ATM (or very close to ATM) and buy the wings, I can move my long strikes out further and further based on the premium I get for the ATM strikes 

for example if the spot (stock) price is $100 and an ATM put and an ATM call each have an individual premium of 3.0 then I could buy the a put at 97 and a call at 103 (or as close as I can get to that).  As I am thinking (rightly or wrongly), if I get a premium of 3.0 for each ATM option that means my 'break even' point is between $97 and $103 in other words if the spot price stays at or between $97 and $103 I am in a profit zone for me, correct?

I believe what I want to happen as the seller is for the IV to go down (and therefore premiums to go down too) so I can buy back for less than the credit I sold it for, right ?

I guess the thing that concerns me is, assignment because if someone paid for an option (e.g. one of my ATM strikes) and the option moves even slightly ITM, why would the buyer 'not' exercise their option, after all they paid a premium for it and it is now ITM, perhaps if it is not deep enough ITM for the buyer's purpose (e.g. just hedging) and therefore not worth exercising.

Any comments on my understanding and thoughts above please ?

Also, are they any statistics showing the percentage of ATM (or very close to ATM) options that are never exercised ? 

Thanks very much all

CXMelga

 

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If you're trading index options they're European style and can't be exercised early.  

Equity options are American style and can be exercised early but it rarely makes sense for someone to do it.  I don't have statistics on it but if they're liquid options it's not something I worry too much about.  The few times I've been exercised I just close the rest of the trade 

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I´m no specialist here, but an assigment risk is way higher if the option is deep ITM and/or ITM and close to expiration --> since there is no (or very little) extrinsic value.

Extrinsic Value is the value aside from the difference between the strike and the price of the underlying for ITM options. Example:
Strike 98
Price of underlying: 100
Price of Call option: 2.5
Intinsic Value is 2 (100-98)
Extrinsic Value is 0.5

As long as the option has some extrinsic value, it is generally better for the optiton holder sell it than to excercise. Being assigned is not always bad, it means you do not have to pay the extrinsic value (compared to buying the option to close your position). Hope this helps.

Edited by RLV

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