Stocks & Commodities V. 30:7 (52): Explore Your Options by Tom Gentile

Explore Your Options by Tom Gentile

FLYING RISKS

Can you explain what extra risks I would assume with a long butterfly position if assigned on any or all of my short contracts?

Great question. First, realize a forced assignment in a long butterfly position won’t open up the trader to more dollar risk. The assumed debit and maximum dollars at stake when the position was opened remains the same, no matter how many of your short calls or puts are assigned. This is because you are hedged and contract neutral. Understanding you are essentially in a covered position, as far as dollars at risk are concerned, might be easier if you break down the long butterfly into its component spreads of one bull vertical and one bear vertical and look at different assignment scenarios. To illustrate, assume you have a one-lot XYZ 30/35/40 (1 x ‑2 x 1) long call butterfly established for $1.50. With shares at 37, you receive assignment on one of your two short 35 calls. Now short 100 shares as part of your overall position, you can exercise the long 30 call to flatten the stock inventory. The exercise, which is your right to buy 100 shares at 30, maximizes the value of the 30/35 bull vertical as you were already forced to sell or short shares at 35.