38 lines
2.9 KiB
Plaintext
38 lines
2.9 KiB
Plaintext
Chapter 10: Tire Butterfly Spread 207
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can estimate that the commission cost for each option is about 1/s point. That is, if one
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has 10 butterfly spreads and the spread is currently at 6 points, he could figure that
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he would net about 5½ points after commissions to close the spread. This 1/s estimate
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is only valid if the spreader has at least 10 options at each strike involved in a spread.
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Normally, one would not close the spread early to limit losses, since these loss
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es are limited to the original net debit in any case. However, if the original debit was
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large and the stock is beginning to break out above the higher strike or to break down
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below the lower strike, the spreader may want to close the spread to limit losses even
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further.
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It has been repeatedly stated that one should not attempt to ''leg" out of a
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spread because of the risk that is incurred if one is wrong. However, there is a
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method of legging out of a butterfly spread that is acceptable and may even be pru
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dent. Since the spread consists of both a bull spread and a bear spread, it may often
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be the case that the stock experiences a relatively substantial move in one direction
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or the other during the life of the butterfly spread, and that the bull spread portion
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or the bear spread portion could be closed out near their maximum profit potentials.
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If this situation arises, the spreader may want to take advantage of it in order to be
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able to profit more if the underlying stock reverses direction and comes back into the
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profit range.
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Exampk: This strategy can be explained by using the initial example from this chap
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ter and then assuming that the stock falls from 60 to 45. Recall that this spread was
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initially established with a 3-point debit and a maximum profit potential of 7 points.
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The profit range was 53 to 67 at July expiration. However, a rather unpleasant situa
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tion has occurred: The stock has fallen quickly and is below the profit range. If the
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spreader does nothing and keeps the spread on, he will lose 3 points at most if the
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stock remains below 50 until July expiration. However, by increasing his risk slightly,
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he may be able to improve his position. Notice in Table 10-3 that the bear spread por
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tion of the overall spread - short July 60, long July 70 - has very nearly reached its
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maximum potential. The bear spread could be bought back for ½ point total (pay 1
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point to buy back the July 60 and receive½ point from selling out the July 70). Thus,
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the spreader could convert the butterfly spread to a bull spread by spending ½ point.
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What would such an action do to his overall position? First, his risk would be
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increased by the ½ point spent to close the bear spread. That is, if XYZ continues to
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remain below 50 until July expiration, he would now lose 3½ rather than 3 points,
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plus commissions in either case. He has, however, potentially helped his chances of
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realizing something close to the maximum profit available from the original butterfly
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spread. |