The high cost of buying an outright call or put option on many markets makes ownership quite expensive and in most cases a bad bet unless held for a short period of time. The vertical spread is my first choice in placing a bet on which direction the market will go. That is a great strategy to use when you feel the market can move significantly in one direction; but to capture a larger profit on a bigger move, the vertical spread becomes expensive as well.
The next strategy to look at is the butterfly spread (the Fly). The Fly spread lowers the cost of buying an outright option when you need more than three months until expiration. The ultimate goal of this spread is to forecast where the market will be at expiration. If correct, the reward is great; if partly right, the reward is very good; and if barely right, you still get even money. If wrong, you know exactly what your risk is and the exact amount you will lose.
The other benefit of this spread is that in any major move against your position, you still have time for the market to do what you thought. No need to become emotional or be forced to exit your trade before you decide whether your market projections are still valid.
The simplest way to look at this spread is to understand that it is two vertical spreads. One spread you buy and one spread you sell. Here is one example:
March ‘08 crude oil settled at $96.05 on Nov. 23, 2007, its options expire on Feb. 14. The March 95 call settled at 586 ($5,860 at $10 per tick), the 100 call settled at 373 and the 105 call settled at 229.
Buy 1 CLH8 95 call @586
Sell 1 CLH8 100 call @373
On Nov. 23 you would have paid 213 ($2,130) for the 95/100 vertical call spread. Now:
Sell 1 CLH8 100 call @373
Buy 1 CLH8 105 call @229
You would have collected 144 ticks. Your total cost (not including fees) for the 95/100/105 Fly on Nov. 23 is $690 (213-144= 69 or $690).
This strategy is reflective of the opinion that on expiration, March crude oil will be trading at $100. If correct, you paid $690 plus commissions and it is worth $5,000. Almost a 6 to 1 risk/reward, and if you use a $340 sell stop, a 12 to 1 risk/reward. If oil settles at $98.50, it would be worth 350 ticks ($3,500), about 4 to 1 after paying commissions.
An outright 95 call costs 586 ($5,860) and would be purchased because you thought that it could go to $106 for example. If it did indeed go to $106, your profit would be $5,140. You paid $5,860 for an $11 move ($11,000-$5,860= $5140 profit). Not even 1 to 1 risk/reward and it had to go to $106 to get that!
Instead of buying the outright 95 call for 586, or the 95/100 spread for 213, I can buy the Fly spread for 69 ticks plus commissions. At $95.69 you get your 69 ticks back, and if wrong and the market goes down, you lose 69 ticks, instead of 213 or 586. The 95 call has the high cost of time decay working against it, with the vertical spread greatly reducing that cost, and the Fly really taking most of it away.
If the market was at the same price of $96.05 on expiration as it was on Nov. 23, the outright call would be worth $1,050, creating a loss of $4,810; the 95/100 call spread would be worth $1,050, creating a loss of $1,080; and the Fly spread would be worth $1,050, a profit of $360. With the 95/100/105 Fly, the most you can lose is what you paid, and that would happen below $95 or above $105 at expiration. The most you can make would be if the market closed at $100. If you think you can pinpoint the market, or believe you can be close, you can greatly reduce your risk and greatly improve your reward using the Fly. This strategy rewards you nicely if only partially right.
Howard Tyllas is registered with the CFTC as a floor broker and CTA. He’s a member of the NFA and a veteran trader of 31 years. He has traded options on futures since their inception. www.howardtyllas.com.