Stocks & Commodities V. 30:3 (44-45): Explore Your Options by Tom Gentile

Explore Your Options by Tom Gentile

A BROKEN BUTTERFLY?

Being relatively new to options, I’m paper trading various strategies until I thoroughly understand them and commit real capital. One position that’s stumped me is a long butterfly using two contracts (2 x (4) x 2) purchased for $1.00. The stock proceeded to dive shortly thereafter and much to my surprise, instead of a maximum loss I thought was contained to $200, the position was down more than $1,200! Can you help explain this to a slightly disconcerted newbie?

First, let’s start off with a bit of congratulations on your willingness to learn the mechanics of option trading and smart sense to utilize your broker’s paper trading platform as an integral part of that process. As for your long butterfly position, it sounds as though you have a modified version of this spread, with a larger embedded, sold vertical as your likely profit & loss culprit.

Say what? Know this: a long butterfly can have a unique risk profile with greater losses than the initial debit if the purchased vertical (either lower bull call spread or higher bear put spread) is tighter than the sold vertical component. Similarly, long butterflies can be modified with different ratios such as 1 x (3) x 2 with equal strike distances for the verticals and yield similar lopsided risk on one side of the spread.