Sep. 8th 2004, Unbalanced Butterflies hosted by Tom Preston tpreston: Good Afternoon everybody!

tpreston: Today, we'll talk about unbalanced butterflies tpreston: I'll cover some material for 15 minutes or so, then open it up for some questions. tpreston: Generally speaking, butterflies have the same number of long options as short options. That is, the net number of options in the position is zero. tpreston: The standard 1x2x1 butterfly, for example the QQQ 34/35/36 call butterfly, is long +1 QQQ 34 call, short -2 35 calls and long +1 36 call. The maximum risk of this butterfly is the amount you pay for it, and the maximum profit is the difference between the strikes (in this case 1.00) minus the amount you paid. It's easy because the different between the lower strike and the middle strike is the same as the difference between the middle strike and the higher strike. tpreston: If you add up all the long options and the short options, they net to zero. And when you see any 3-legged spread where the long and short options net to zero, it will often be termed a butterfly. tpreston: But all butterflies are not created equal. tpreston: There are types of butterflies that we term broadly "unbalanced" butterflies that can be quite different from standard butterflies. tpreston: The first unbalanced butterfly is long +1, short -2 and long +1, but the strikes are not equidistant. tpreston: For example, in the QQQ long +1 34 call, short -2 35 calls and long +1 38 call. The long and short options net to zero, but this "skipped strike" butterfly is quite different than a standard butterfly.

tpreston: This unbalanced 1x2x1 butterfly is cheaper than a standard butterfly, and sometimes can even be established for a credit. Does that mean that you're buying butterflies for credits? tpreston: NO! tpreston: The unbalanced 1x2x1 has a short vertical embedded in it that creates the credit but increases the risk of the position over the standard butterfly. tpreston: For example, the long +1 34 call, short -2 35 calls and long +1 38 call unbalanced butterfly is really long one standard butterfly and short a call vertical. tpreston: The long standard call butterfly is long +1 34 call, short -2 35 calls and long +1 36 call, and the short vertical is the short -1 36 call and long +1 38 call. The long +1 36 call from the butterfly offsets the short -1 36 call from the vertical. That's why you don't see any 36 calls in the 1x2x1 unbalanced butterfly. tpreston: It's that short call vertical of the unbalanced 1x2x1 butterfly that increases the maximum risk beyond that of a standard butterfly. tpreston: If you received a .05 credit for that 34/35/38 1x2x1 unbalanced butterfly, your maximum risk would be $195, which is the maximum value of the short call vertical if the QQQ goes above 38. tpreston: There is also a margin requirement on the unbalanced 1x2x1 because of that short call vertical. tpreston: Now, that doesn't necessarily make it a bad trade, but you have to be aware that the unbalanced 1x2x1 can have a lot more risk than a standard butterfly. tpreston: Another type of unbalanced butterfly is the 1x3x2. An example in the QQQ would be long +1 33 call, short -3 35 calls and long +2 36 calls. This 1x3x2 unbalanced butterfly has long and short options also net out to zero, but it is very different from the 1x2x1 unbalanced butterfly.

tpreston: The 1x3x2 is really 3 butterflies in one package. There is one butterfly made up of long +1 33 call, short -2 34 calls and long +1 35 call. There are two butterflies made up of long +2 34 calls, short -4 35 calls and long +2 36 calls. tpreston: The short -2 34 calls from the first butterfly offset the long +2 34 calls from the second butterflies. And the long +1 35 call from the first butterfly and short -4 35 calls from the second butterfly net out to short -3 35 calls. tpreston: For this1x3x2 unbalanced butterfly, the maximum risk is what you pay for it, and it's maximum profit is difference between the strike with short -3 options and the strike with long +2 options minus the amount you paid. If you paid .70 for the 1x3x2, the max loss is .70 and the max profit is 1.30. tpreston: The point is that even if a strategy is called a butterfly, it is not necessarily the same as the relatively simple standard butterfly, and that you should look at unbalanced butterflies carefully to see if there are any embedded short verticals that could cause a problem. tpreston: When would you use an unbalanced butterfly? tpreston: You might consider a 1x2x1 unbalanced butterfly if you wanted to buy a butterfly and finance it by selling a vertical that has a high probability of expiring worthless. tpreston: The only trouble is that the vertical that has a high probability of expiring worthless may have a credit that is so low that it only offsets the cost of a butterfly that is so far away from the current stock price that it is cheap. tpreston: And if the stock or index moves enough to make that butterfly profitable, it might continue and blow right through the short call vertical. That's why 1x2x1 butterflies are tough to manage. tpreston: A 1x3x2 unbalanced butterfly can be used if you think the stock or index will be in between the long strikes near expiration, and you can buy the package of 3 butterflies for a good price. If the stock goes between the long +1 strike and short -3 strike, you might be able to sell that single

butterfly for a profit and be left with the long +2 butterflies to wait for the stock to go to their short strike. tpreston: OK, let me open it up for some questions. COD: how do you place an unbalance fly via TOS platform, tom? COD: or have to call desk? tpreston: Cod, you can enter unbalanced butterflies from the TRADE page. tpreston: For an unbalanced 1x2x1, you click into a butterfly, then change the strikes in the order entry panel to whatever you want them to be. tpreston: For an unbalanced 1x3x2, you right click on a bid or ask to bring up the spread menu, then find "unbalanced" at the bottom of the list. tpreston: When you click on "unbalanced", select "Butterfly" to create a 1x3x2 unbalanced COD: I see vignesha: can we have butterflied with more longs then shorts (three strike prices of course).. say 1 X3 X4..are they still called buterflies tpreston: vignesha, I suppose you could call that position that is net long options a butterfly, but that particular configuration (1x 3x 4x) would be a butterfly plus a back spread. COD: How do you dissect a pregnant bfly, Tom. Say +1 30call/-2 34calls/+1 38 calls? tpreston: Cod, the 30/34/38 butterfly is just a stretched out butterfly. It has butterflies embedded in it. tpreston: The number of butterflies you have is the difference between the strikes, squared.

tpreston: it would take a long time to type the whole dissection out, but it's long +1 30/31/32 butterfly, long +2 31/32/33 butterflies, long +3 32/33/34 butterflies, etc tpreston: The max is long +4 of the 33/34/35 butterflies, then you go back down to long +1 36/37/38 butterfly COD: ok, thanks Tom kawasakikim: i had a bfly on oex last month i was able to buy and sel the body few times before the trade fell apart tpreston: You mean you scalped the short options in the butterfly, kim? kawasakikim: 520 525 530

kawasakikim: so every time it went near 520, i buy it back then sell it again as it went near 525 or more kawasakikim: finally i was just left with long positions kawasakikim: which i tooksome loss tpreston: That's one way to trade butterflies, kim, but you're taking significant directional risk when you do. kawasakikim: i always leg it in i construct the trade with intar day fluctuations tpreston: Only very experienced traders should try legging into butterflies, or any spread with 3 or more legs tpreston: It's very easy for the stock or index to move against you and leave you legged out. While you're legging in, you're taking on directional risk, which you may not want to do. COD: Is unbalanced fly order more difficult to get fill?

tpreston: Yes, Cod, they can be tougher to get filled, especially these days when trading is slow.

ckor30: What is a "Gut" butterfly? when would you use it? tpreston: ckor, a "gut" butterfly is more of an iron condor type of strategy. A regular iron condor is short an out of the money put vertical and short an out of the money call vertical. tpreston: a "guts" iron condor would be long an in the money call spread and long an in the money put spread. tpreston: synthetically, the "gut" position is the same as the regular position. The "guts" position has synthetic long boxes, while the regular position has synthetic short boxes. tpreston: ckor, one problem with the "guts" position is that you have early exercise issues for American style options, and exercise fees at expiration. ckor30: So, when would you prefere a Gut instead of a regular? tpreston: ckor, I would not choose a "gut" position over a regular position unless I spotted some pricing advantage in the "gut". But that would be very rare to find that. ckor30: thanks Tom thenakedtrader: but I like the way you showed to deconstruct the 1-3-2 into multiple butterflies, Tom tpreston: Thanks, nakedtrader, being able to see a complex position as a bunch of components is helpful in pricing and position management. COD: that's why Tom I didn't see embedded flies in your first example--I view is as 2 verts. You are simply amazing tpreston: Thanks, Cod.

vignesha: i have heard people using double bflys one on the call side and one on the put side...(say 31-33-35 on the put side and 35-37-39 ) on the call side...any commets tpreston: vignesha, double butterflies are simply bets that the stock or index will move in some direction, but not stay still. tpreston: I would avoid buying too many far out of the money butterflies that seem like good buys because they're cheap. But more often than not, they expire worthless. tpreston: So, if you buy butterflies closer to the current stock price, you will pay more, but have a better chance of success. So, double butterflies could be costly. vignesha: May be they are good for adjustments if we can buy the shorts back early in the option cycle tpreston: vignesha, I don't know if I would want to buy the short options of a butterfly, or even double butterfly, too far from expiration. tpreston: That would leave the position open to a lot of delta risk that the original butterflies wouldn't necessarily have. vignesha: Thats a good point Mr_Boo: tom fly's are not a very trade in volital markets? tpreston: Mr. Boo, butterfly values typically get pushed lower when volatility goes up. tpreston: That's because in volatile markets, the stock or index might wind up far away from the short strike of your butterfly. COD: so it is better to sell fly when vol is up? tpreston: Cod, no, just because vol is up doesn't mean that you should sell butterflies.

tpreston: Because I believe that current front month volatility is a very good predictor of future actual volatility, the butterflies are probably pretty accurately valued in any vol environment. tpreston: But if you think that the actual volatility of the stock or index will be low, yes, you could sell out of the money butterflies expecting them to expire worthless. johnebiz: Does it make sense to buy call ratio backspreads, say for jan06 and then buy butterflys in near months to help pay for the downside risk of the backspread (at its expiration)? tpreston: johnebiz, I suppose you could trade front month butterflies against further month back spreads, but if you're wrong on the butterflies, you could increase the cost basis of the position significantly. johnebiz: I like the back spreads now that vol is relatively low. Other than flys or condors, what would you suggest to minimize the risk in the backspreads? tpreston: johnebiz, you might want to consider diagonals, where you sell the front month lower strike call and buy the back month higher strike call. tpreston: You could buy more back month calls to create a sort of ratio diagonal. Kogan: Tom, to what extent is the IV an accurate predictor for front month actual vol? I recall Natenberg mentioned that at least in index markets, IV tends to usually overestimate actual vol by a small margin. Do you still find this to be true? tpreston: Kogan, I would agree that implied vol overpredicts price movement in the small to intermediate range, but underestimates the huge moves that are possible. tpreston: OK everybody, I have to wrap it up. tpreston: Thanks for coming today. johnebiz: Thanks. Have a great week.

Mr_Boo: thank for the chat tom time for beige book t.preston.admirer: tpreston... once again you have out done yourself, shattered all expectations....only 6 days and 23 hours till next we meet thenakedtrader: Thank YOU Tom, for another informative and interesting chat! :) Kogan: Thanks, Tom. Yeah, those fat tails are a problem. lotz9ez: Thanks for all the good Information. tpreston: You're welcome tpreston: See you next week!