Cocooning Through the Market's Slumber - TheStreet

"Do not touch nothing. The truth will be revealed by the facts as they exist."

This was Hercule Poirot's first and essential order for solving the

Murder on the Orient Express

. The quote sprang to mind as I pondered the growing frustration among options traders, who find themselves increasingly confounded by the riddle presented by the market, and the resulting search for ways to make a profit. The clues include rising stock prices, declining volatility and a clock moving steadily toward the end-of-year terminal destination.

The Poirot strategy of establishing an objective, static position to best observe the underlying moving parts is much like an options trader's use of the butterfly spread. A butterfly is a three-strike position involving the sale (or purchase) of two identical options, together with the purchase (or sale) of one option with an immediately higher strike, and one option with an immediately lower strike. All options must be the same type and have the same expiration date. One way to think of butterflies is as a combination of two vertical spreads -- one bullish and one bearish, with a common middle strike.

By Any Other Name...

The name is undoubtedly derived from its structure of a midsection and two equidistant outside pieces, creating a profit/loss diagram with two "wings." Being a bit of a romantic, however, I like to think that it refers to a position that starts off as essentially neutral and, without touching it during most of its lifespan, has the potential of emerging as a beautifully profitable position.

Whatever its etymology, the term can be intimidating to some investors who believe the butterfly spread is a complex strategy best left for professional or sophisticated traders. My current attraction to butterflies is that they provide a low-maintenance strategy with a limited risk/reward profile that isn't altered by a change in implied volatilities.

Which Way to Fly?

There are two basic types of butterflies: short and long. The short butterfly involves selling the outside strikes and purchasing the inside. Its maximum profit is equal to the net premium collected and is realized if the underlying asset is below the lowest strike or above the highest strike at expiration. The maximum loss is realized if the underlying asset settles at the middle strike and is equal to premium minus short spread. Professionals are more likely than retail traders to employ short butterflies, because by building an inventory across many strikes, they can take advantage of pricing relationships by trading off these established spreads.

The long butterfly consists of buying the outside pieces and selling the inside. Assume shares of XYZ Corp. are trading at $40. Here's what a long butterfly would look like:

  • Long one 35 call (or put)
  • Short two 40 calls (or puts)
  • Long one 45 call

The maximum profit of the long butterfly is the value of the long spread minus the premium paid, and it is realized if the underlying settles at the middle strike on expiration.

An Example

Let's look at a long call butterfly in the

Semiconductor HOLDRs

(SMH) - Get Report

. With SMH trading at $39.40 on Wednesday, the table below shows the December 37.50, 40, 42.50 butterfly spread.

As you can see, the net cost is only 30 cents, while the maximum profit is $2.20 if SMH settles at $40 on the Dec. 19 expiration. That would make a nice holiday gift without having to do much.

An important pricing dynamic of the butterfly position is that its theta, or price sensitivity to time decay, accelerates significantly as the expiration date approaches. That means the spread's value (and delta) will remain relatively constant regardless of the underlying asset's price movement until there are less than about three weeks remaining.

At that point, the position becomes increasingly sensitive to price movement. It also means that maximum profits can't be realized unless the position is held until expiration. That's why these are sometimes referred to as "vacation positions." They're low-cost and have minimum risk; you can establish your position and then forget about it for a while.

While I don't like to present option positions as lottery tickets that produce maximum profit when landing "on the number," the current combination of a lack of market direction and low volatilities in both implied and real terms makes this a good time to watch the market reveal itself.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.