Traders Edge Blog

Karson Keith’s Options Insight:
Long Butterfly Delivers in Tough Market

With the VIX so low recently, it has become increasingly more difficult to make money from melting time decay. Investors are under-compensated for risk. The market has continued to be volatile while the VIX has spent most of its time hanging out in the high teens to low twenties. This is largely due to the lack of positions in the market. Many institutional traders remain on the sidelines because they don’t want to deal with the turmoil going on in the world. Individual investors are finding the current environment challenging, as they struggle to make money in the markets utilizing conventional trading approaches.

Though current conditions are less-than-ideal for generating income in the markets, I continue to find great success with well-timed long butterfly positions. I have had an average weekly return in excess of 20 percent trading the long butterfly over the past seven weeks.

The typical scenario for trading a long butterfly is to put it on near expiration and then hope that the stock doesn’t make a move before it expires. I don’t like to use a long butterfly during that time frame, preferring instead the possibility of a short butterfly. My usual long butterfly entry is on Friday, using the options that expire the following week (seven days out).

Oftentimes I’ll hold the position over the weekend and then take it off the table on Monday. If the stock is relatively calm I’ll consider holding the position into Tuesday to melt away more time decay. If the stock continues to stay calm I’ll take off half the position and hold the remaining half into Wednesday. It’s rare that I will hold a position beyond Wednesday, given that’s when the butterfly is most sensitive to a move in the stock.

One of my favorite stocks to run this strategy on is CAT, with $5 spacing between the legs. It has yielded nice returns nearly every week.

In conclusion we can still generate income from time decay; we just need to be smart about it!

Karson Keith

 

Karson Keith’s interest in trading started at a very young age. By age 13, he began trading and managing his father’s money. Today, his passion for trading has attracted a following of like-minded income traders seeking his help in taking their trading to the next level. Karson specializes in cutting-edge options strategies, volatile markets and small trading accounts. He not only has single-handedly grown several small accounts into large portfolio margin accounts within just a few months, but he has also helped countless people achieve the same results.

Monster’s Perspective:
How Mark Cuban Saved His Fortune

My friend Mark Cuban is known for many things, but not many people are familiar with his acumen in the markets. His best trade may have been one that saved him from losing his fortune. Long before he became owner of the Dallas Mavericks, Cuban used a collar trade to lock in profits from his $5 billion-plus sale of Broadcast.com to Yahoo at the height of the dot-com bubble. The trade gave Cuban exposure to some upside but limited the downside in a position where he could not sell the stock due to a lock-up period prohibition. This is obviously an extreme example, but it underscores for all of us the value of collar trades in situations where you must own the underlying asset. They can be designed in a variety of ways to protect positions and/ or profits.

One of the great things about being a retail trader is that you usually don’t have to hold onto such positions. For example, a bull call vertical spread has essentially the same profit/loss profile as a collar, without the necessity of owning the stock. The margin requirements are also significantly lower on a call spread than on a collar. (See our Education section.)

Still, there are other lessons to be learned about the Cuban trade, including the concept of the zero-sum game. This is an idea that trips up a lot of new players in the option market.

If we flip a coin and you get $1 on heads and I get $1 on tails, that is a zero-sum game. But people use options in different ways and for different reasons, so it is far more complex than that. For example, we recently could have bought an SPY March 128 call for $4, with the SPY trading at $126. On March 1, 2012, it was worth $10 when the SPY was priced near $137. So the call buyers profited and the call sellers lost, correct? Well, not necessarily.

Certainly the outright buyers profited if they held the calls. They made $6 on a $9 stock move, equating to a 150 percent option profit. Even as time decay accelerated, the calls went further into the money and produced profits.

But if sellers simply treated the trade as a covered call, they profited $6 as well, earning $2 on the stock move up to $128 and a $4 credit for selling the call.

The call seller could also have been delta-hedged, which is what market makers do. When you buy a call the other side of the trade is almost certainly a market maker who immediately hedges the sale with stock. Such hedged positions essentially equate to selling the implied volatility of the stock and collecting the actual volatility—making a profit on the difference between the two.

The implied volatility of the SPY options at the end of 2011 was around 22 percent, while the actual volatility last week was less than 8 percent. So the dealer who sold the call and delta-hedged it also made a very nice profit.

This goes to show that just because one person turns a profit on options doesn’t necessarily mean that money was lost on the other side of the trade. Of course, being realistic, it is entirely possible that both sides lose on the play as well.

That’s why it’s so misleading to call this a simple zerosum game.

Jon “DRJ” Najarian

 

Jon ‘DRJ’ Najarian is co-founder of optionMONSTER® and co-lead analyst for the InsideOptions™ trade idea alert systems. He spent the first 29 years of his trading career trading in and around the pits of the Chicago exchanges. Jon is a frequent contributor to CNBC, the Wall Street Journal, and other prominent financial media organizations. Mr. Najarian also co-developed the patented trading algorithm the Heat Seeker®, used to detect unusual trading activity.