The Perfect Options Play
Found this strategy which some say is the perfect options play.
A Butterfly on the front month that is done for a credit. Buy +1 put @ $9.50 Sell -1 call @ $10.00 Sell -1 put @ $10.00 Buy +1 call @ 10.50 This gives you your typical butterfly that will carry positive theta at the $10.00 strike and around it while also limiting your losses to the outer strikes. So with the butterfly would want the stock to sit still and not move which in and of itself is a good strategy for many.
So then we add a WRANGLE on the back month which is also a form of a back spread. However, we sell the 100 strikes yet again to keep our credit. So…. Buy +2 put @ $9.50 Sell -1 put @ $10.00 Sell -1 call @ $10.00 Buy +2 calls @ $10.05 Long Wrangle! What this does is, it’s basically a back spread that will give us long vega and long gamma exposure should the stock take off or collapse. So when you put the spread together, you start off delta neutral, theta positive, and no vega exposure. You will be earning time premium and hope that the stock just sits there.
However if the stock starts to move, you will still be making money during the front month no matter what. If the stock really moves hard then the position will turn into a long gamma, long vega position in which your theta will go negative. However you can also let your deltas run or you can gamma scalp them. After the front month butterfly expires, you will be losing money if the stock sits still and stops moving so you can then put on another butterfly. At expiration on the back month you will have a range where you will lose money after only a moderate move in the stock. But if the stock either sits still or breaks one way or the other you have unlimited profits. We have the best of both worlds here, a credit spread that earns premium as long as the stock sits still and doesn’t move and if it does move we then have a long gamma long vega position that could make us unlimited profits. Hence a very very versatile strategy.
If you put enough of these on, you could really spread your risk out. Of course you can always alter the strikes to change your profit range. By widening the strikes on the front month butterfly, you reduce your profits slightly but increase your odds of making money during the front month. Skew is really important here because in general you have what is called a volatility smile working against you. If you don’t know what that is just picture a big fat smile on a graph. At the bottom of that graph and the bottom of the smile its flat, that is where the ATM strike is and where the vol tends to be the lowest. But as you move out to the OTM calls and the OTM puts the Vol skews higher with each strike therefore creating the proverbial volatility smile. This works against you because you are in essence selling low vol and buying higher vol on the wings. Your goal should be to try to find stocks where the skew is as flat as possible. Of course by legging into these options you will be synthetically flattening the skew by getting better prices. But there are a lot of scanners out there that will scan just for skew and will provide you with lots of good plays to try this spread on. The other thing I would look for is find strong stocks! Not weak stocks.
You want to put on plays where the volatility is very very low because remember, once the stock moves out to the wings you will now have a long vega position and will therefore be vulnerable to decreasing volatility. Also look for stocks that are in a tight range and not moving much so that if they do break out you might get a stronger move and more follow through. So to sum up, I would look for stocks near 52 week highs that have low volatility and flat skew The purpose of this play is not keep rolling new butterflies. In fact the fly really doesn’t do a whole lot for this position. It’s purpose is to allow you to be back spread on the far month for anywhere from a small credit to a small debit. That’s it! Yes a by product of this play should the stock not move and stay at the center strike, then yes, you will earn a profit on the spread by locking in a nice gain on the front month fly and now you can hold the wrangle for free with unlimited upside! There is risk as you approach the front month expiration. It’s not a huge risk but a small one. As you approach the wings of the front month fly you are going to risk locking in a small loss on that fly if the options expire there.
However having said that, by having the back spread on the far month that will cushion the blow you would experience had you just put on a front month fly. That’s the beauty of the position. See if you would do these trades separately, you would have two very different risks. If you just did the front month fly you risk have the stock making a big move to the wings and locking in the max loss. If you just did the back spread, you would be exposed to the theta of that position and the long premium. But, by combining the two, both the strengths and the weaknesses compliment each other. So by having the stock move to the wings of the front month will kick in the back spread to avoid any large losses and by having the fly on the front month, you avoid large losses by holding a long premium position that doesn’t move. Hence the perfect option position!
