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Know Your Options - Mailbag Edition

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I received an email from a reader that contained some interesting questions that I'm guessing others might be wondering about as well, so for this week’s “Know Your Options”, I’m simply going to answer him.

Paul wrote:


I read the Know your options articles you publish. I am newer to options trading and have a couple questions I was hoping you can clarify.

1)      I’ve been looking at credit spreads in times of such volatility, short butterfly strategies in particular. I’d like to hear your input on why you prefer to Strangle(most recent article) rather than collect premium with a strategy like a short butterfly in times of high volatility?

2)      I’m struggling to have my orders fill with the example:


SPY trading at ~$250

Buy 2 $250 calls

Sell 1 $255 call

Sell 1 $245 call


I’ve tried different expirations where I’m seeing a big spread to enter this position but I’m not able to have this order execute with what I feel like is a fair credit.


3)      What is an ideal credit to receive? Do you typically base this on a percentage of the width of strike prices, specifically, In the above order the width of my strikes would equal $500, should I be looking to collect a credit of no less than 25%, 20%.... 50% of this width? I’m using the above example but I would imagine this logic could apply to several credit spreads.


Thank you David and the Zacks team,



First of all, Thanks for being a reader, Paul. Options can be a great way to customize your portfolio’s risk/return ratio if you understand how to use them and I hope the column is helpful.

1)      In previous columns, I have definitely advocated making trades that sell net option premium during periods when the markets are pricing options at high implied vols. In the recent column you mentioned, I was actually making a case for the opposite strategy, even though vols have been elevated lately.

Having observed several intraday market moves recently of much greater magnitude than even the high implied vols would suggest, I was pointing out that a trader could make money by owning both calls and puts, and then either selling out of part of the position or hedging with the underlying when big moves occur.


2)      This is partly a strategy issue and partly an execution issue (the answer to which will depend on which platform you are using to execute trades), but I can give a general example that hopefully will clarify things.

First the strategy part:

The spread you describe is a short butterfly. You will collect a small premium that you will keep if the underlying is outside the range of $245-$255/share, and you will suffer the maximum loss -which is the difference between the strikes minus the premium you originally collected - if the underlying is right in the middle - $250/share.


Using current prices for the SPY options that expire on January 18th, you could expect to collect about $0.75 to sell the butterfly, which would be your maximum profit, and you could lose up to $4.25 if SPY was trading at exactly $250/share at expiration. The p/l diagram looks like this:



Now the execution part:


(This is how I arrived at the $0.75 credit for the trade.)


The market prices I observed were:


(SPY - Free Report) - $252.35

                                Bid                          Ask

Jan 245 call             $9.67                     $9.85

Jan 250 call             $5.98                     $6.05

Jan 255 call             $3.08                     $3.12


If you were simply to execute the trade at the prevailing market prices – selling bids and buying offers, you’d collect $0.65. (Sell one 245 call at $9.67, buy two 250 calls at $6.05 and sell one 255 call at $3.08.) This is basically the worst case scenario for execution, paying the entire bid/ask spread on each leg of the trade, but if you were willing to sell the spread at this price, you’d be guaranteed to get the trade executed.


If you were lucky enough to do the opposite, you’d sell one 245 call on the offer at $9.85, buy two 250 calls on the bid for $5.98, and sell one 255 call on the offer at $3.12. In this case you’d collect much more - $1.01 – but there’s also essentially zero chance that any potential counter party would trade with you at that price.


So the midpoint of the bid/ask of this spread is $0.83.


If the platform you are using to enter orders allows you to enter the trade as a spread, I would expect that you wouldn’t have to pay the entire bid/ask spread on each option because the trade offers less risk to a counter-party (who will probably be a professional market maker) than trading any of the legs individually, but I wouldn’t be too hopeful of selling it at higher than the midpoint, either.


If I were going to sell this spread, I’d try to offer it at $0.75 first to see if anyone is interested and I think I’d have a reasonable expectation of getting filled.


3)      With spreads that contain options that expire at the same time and have similar strike prices, it’s going to be unlikely to find any really serious mispricings. The options markets are much too efficient for anything like that to exist for more than even a fraction of a second.


In this case, there’s not really an implied volatility component to this trade (because all the options are trading at very similar implied vols), it’s simply a bet that SPY will move – and stay -  outside the 245-255 range before expiration.


Personally, I don’t have a strong opinion about where SPY will be trading on January 18th. I don’t have any reason to believe that this butterfly is cheap or expensive, either in absolute terms or as a percentage of the distance between the strikes. My gut feeling is that the market has it priced fairly.


If you do feel strongly that the S&P 500 will move significantly in the next two weeks - which is of course not an unreasonable assumption – selling this butterfly is an opportunity to make $75/spread if you’re correct. Understand however, that you could lose up to $425/spread if you’re wrong.

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