The butterfly has lower nominal risk—only 0.10 compared with 0.35 for
the call spread. The maximum reward is higher in nominal terms, too—0.90
versus 0.65. The trade-off is what is given up. With both strategies, the goal
is to have Walgreen Co. at $36 around expiration. But the bull call spread
has more room for error to the upside. If the stock trades a lot higher than
expected, the butterfly can end up being a losing trade.
Given Ross’s expectations in this example, this might be a risk he is
willing to take. He doesn’t expect Walgreen Co. to close right at $36 on the
expiration date. It could happen, but it’s unlikely. However, he’d have to be
wildly wrong to have the trade be a loser on the upside. It would be a much
larger move than expected for the stock to rise significantly above $36. If
Ross strongly believes Walgreen Co. can be around $36 at expiration, the
cost benefit of 0.10 vs. 0.35 may offset the upside risk above $37. As a
general rule, directional butterflies work well in trending, low-volatility
stocks.
When Ross monitors his butterfly, he will want to see the greeks for this
position as well. Exhibit 10.6 shows the trade’s analytics with Walgreen Co.
at $33.50.
EXHIBIT 10.6 Walgreen Co. 35–36–37 butterfly greeks (stock at $33.50,
31 days to expiration).
Delta +0.008
Gamma−0.004
Theta +0.001
Vega −0.001
When the trade is first put on, the delta is small—only +0.008. Gamma is
slightly negative and theta is very slightly positive. This is important
information if Walgreen Co.’s ascent happens sooner than Ross planned.
The trade will show just a small profit if the stock jumps to $36 per share
right away. Ross’s theoretical gain will be almost unnoticeable. At $36 per
share, the position will have its highest theta, which will increase as
expiration approaches. Ross will have to wait for time to pass to see the
trade reach its full potential.
This example shows the interrelation between delta and theta. We know
from an at-expiration analysis that if Walgreen Co. moves from $33.50 to
$36, the butterfly’s profit will be 0.90 (the spread of $1 minus the 0.10