In your column on butterflies you wrote, "Professionals are more likely than retail traders to employ short butterflies, because by building an inventory across many strikes, the pros can take advantage of pricing relationships by trading off these established spreads." Can you expand on this? Thanks for the good stuff. -- N.R.

Expand I can. Let's pile some words upon a couple of the concepts mentioned.

Leaning on the Clock

Professionals would opt for being short butterflies, because they tend to favor having a positive theta or building positions for net credit. By taking in premium, professionals such as market makers can work from a delta-neutral position and gain the edge of having time decay act as a wind at their back. All else being equal, you would rather be short an eroding asset and trade with the clock on your side.

But be aware that credit positions typically carry a much higher risk than reward profile compared with their mirror debit positions. Taking the other side of the July 1125/1175/1225 butterfly mentioned in the referenced column -- that is, selling it -- would mean having a maximum profit potential of just $14 vs. a risk of losing $36 if the index settled at the 1175 midpoint. But the probability of reaping


profit, however small, is about 65% based on the likelihood that the underlying index will move more than 5.5% over the next 10 weeks. I still like the inside bet.

Building an Inventory

Most professional traders look to build an inventory of positions across as many strikes and months as possible, for as little cost as possible. Hence, there is the above-described tendency toward net credit positions. This does not mean one can't build an inventory of butterflies, or any other type of position. For example, in addition to the July 1125/1175/1225 fly described in the recent column, one also could purchase the July 1050/1100/1150 and the July 1200/1250/1300 for net debits of around $6 and $9, respectively.

Notice how further in- or out-of-the-money butterflies tend to have a flatter cost profile than positions using closer-to-the-money strikes. With these three positions, one now has covered a nearly 200-point, or 17%, range in which one can realize a profit. The maximum benefits will be derived if the index is near one of the three middle points, 1100, 1175 or 1250, at the July expiration.

Let's assume we establish the three July butterflies described above. Our total cost is now $29, meaning that even if the index were to land on one of our three "middle strikes," or maximum profit numbers, we still would incur a loss of $8 per unit. This is the unfortunate situation premium owners find themselves in, and it means you better start looking for some short-term opportunities to overcome the time decay.

Trading Off the Establishment

But this is not insurmountable. The real value of establishing an inventory of relatively low-cost, limited-risk positions such as butterflies is not so much hoping for their ultimate payoff, but for the leveraged base they provide from which one can launch trades and profit from short-term price movement.

Let's stick with our original July 1125/1175/1225 butterfly. One approach might be to buy near-term strangles, using May or June options. This buy would be based on the notion that any short-term price movement can be scalped for a profit, while a static market leaves the index closer to our payoff number of 1175. If the index is still at 1175 come June 15, the butterfly will have a theoretical value of around $24, a nice $10 increase from the original $14 purchase price. One would hope the stock will provide some minimal jigs and jags during the next six weeks, scalping the near-term options. If a major move occurs in the stock, the straddle will prove to be an outright winner.

Combine this with butterflies across other strikes and you can see how, no matter where or how the market moves, you should be in a position to respond and profit. But remember, this moves from a "vacation position" toward one that needs to be actively engaged in both monitoring and trading.

There's No Crying in Options, but at Home...

On a note even lighter than a butterfly, my wife and I welcomed our first child, Natalie, into this godforsaken world last Friday. She is healthy and cute, bringing her mom lots of joy and even starting to win me over.

Steven Smith writes regularly for 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