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