From the July 01, 2010 issue of Futures Magazine • Subscribe!

Options strategy: The 1-3-2 trade

Question: Is there an alternative to the broken wing butterfly when it no longer can be done at a premium?
Answer: Yes. The 1-3-2 trade.

One of the strongest criticisms of butterfly spreads is that they do not metamorphose from their larva-like purchase price to their beautiful butterfly-like profitability expectancy until very close to expiration. Traders love the low risk and high potential reward of a butterfly spread, but because they have to wait until close to expiration for a decent return, the stock has ample opportunity to move away from the butterfly’s profitable zone.

Since we published the article on the broken-wing butterfly (BWB), we have received many questions about how to do one with only a few days left and how it relates to a 1-3-2 trade. We have received many excellent questions regarding the dynamics, performance, risks, and benefits of the 1-3-2 trade, and we want to share them with you here.

What is a 1-3-2? Like a broken-wing butterfly, a 1-3-2 trade will lower the cost of the spread through the purchase of a traditional butterfly spread combined with an overlapping short vertical spread. If a butterfly expires out-of-the-money (OTM) on expiration, then the total capital investment is lost. Therefore, although selling a vertical spread to pay for the butterfly has a slightly higher risk, the resultant cost reduction will hopefully outweigh it.

We can play with some IBM numbers to get an understanding of how this trade works. IBM is at $124.45 and we will assume that we are neutral to slightly bearish on the stock’s short-term direction. Looking at an option chain that has 25 days remaining (June expiration), we notice the closing prices: the 125 put, $3.88; 120 put, $2.16; 115 put, $1.26; 110 put, $0.79 and 105 put, $0.53.

We see that the traditional 125-120-115 put butterfly will cost $0.82 per share, or $82 per spread. This is a decent risk-to-reward ratio provided that the stock closes between $125 and $115. The break-even points on the spread are $124.18 (125 strike - $0.82) and $115.82 (115 strike + $0.82). But with the stock currently trading for $124.45, we have to be a little concerned that the stock is closing at $125 or higher on expiration, especially with 25 days remaining. If it closed at $125, we would lose all of our $0.82 investment.

The downside to this trade is that the $0.82 debit can go out worthless. To get back the $0.82, we can sell an OTM put spread. Common sense would tell us that we want to sell a put spread as far OTM as possible, but we know that as the spread goes further OTM we collect less premium. Therefore, we can sell the 115-110 put spread (sell the 115, buy the 110) to bring in $0.47, or we can sell the 120-115 put spread to bring in $0.90. The 120-115 put spread yields a credit of $0.90, offsetting the $0.82 for the traditional butterfly.

We get a new position by combining the traditional butterfly with selling the 120-115 put spread. We have now entered into an unbalanced butterfly, or 1-3-2 trade: long one 125 put, short three 120 puts and long two 115 puts.

The $0.82 debit from the butterfly combined with the $0.90 credit from the put spread sale nets out to be an 8¢ credit, so even if the stock climbs outside our profit range, we will still keep the 8¢ credit.

The spread sale will increase our risk exposure on a break-even basis, but will decrease our risk exposure on a cost basis. “Building a better flytrap” compares the risk graph of the traditional butterfly and the newly formed 1-3-2 trade illustrating the power of this trade. As long as the stock does not fall below our downside break-even point, which is very close to the traditional butterfly’s break-even area, the 1-3-2 trade is superior.

Chart

Most professional options traders prefer the BWB to the 1-3-2 until the BWB entails a debit. Then, they would switch to the 1-3-2. The 1-3-2 can be an excellent trade to implement when volatility is too low or time until expiration is too short to do the broken-wing butterfly without an initial cost.

Alex Mendoza is the chief options strategist with Random Walk, which has produced numerous articles, books and CDs on options trading, including a book on broken-wing butterfly spreads. Visit their Web site: RandomWalkTrading.com.

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