How to Use a 'Put Butterfly' Option Structure: A Case Study With Cummins Inc.

By J. W. Jones  DEC 21, 2012 12:53 PM

It is important to understand that the maximum profitability of these trade structures occurs when price is at the strike of the body at expiration.

 


Entomologists tell us that a group of butterflies can, at the choice of the writer, be termed a lek, a rabble, or a swarm. I was struck today by the bearish Fibonacci-based pattern initially described by Larry Pesavento, which was termed a bearish butterfly, and that had completed in heavy engine manufacturer Cummins Inc. (NYSE:CMI).  

As improbable as it might be, I was pleased to find that a high probability option structure could be used to trade it, the put butterfly. I thought it would be interesting to examine this rabble for educational value.

First, let’s look at the chart pattern. The price pattern termed a butterfly is a high probability reversal pattern that can occur in both bullish and bearish configurations. It is a variant of a two-step pattern and is also a variant of a more commonly known Fibonacci pattern, the Gartley.

The essential elements of the pattern are an initial impulsive thrust (classically termed the X:A leg), a reversal of 0.618 to 1.00 of the initial thrust (the A:B leg), a second thrust in the direction of the initial leg (the B:C leg), and the final reversal thrust opposite in direction from the initial X:A leg extending from 1.272 to 1.618 of the initial leg. 

Verbal descriptions are confusing, but consider the characteristic visual pattern, which is easily recognized once the trader is familiar with the pattern.




The pattern completed last Friday as indicated on the graph, and today’s bearish candle constitutes a trigger for the trade. These patterns have approximately a 67% probability of success.

The option position I chose to trade this pattern is that of a classic put butterfly. For those not familiar with this structure, it is a three-legged structure that is composed of long positions for the wings and a short position for the body. 

The classic butterfly is always constructed in the ratio +1/-2/+1 and the long positions are equidistant from the short position comprising the body. The position is a debit position meaning that money is deducted from the buying power of the account. An option butterfly can be constructed using either puts or calls. It is important to understand that the maximum profitability of these trade structures occurs when price is at the strike of the body at expiration. Therefore, if an individual butterfly is constructed to express a directional bias, it can be constructed using either puts or calls since the strike price of the body determines maximum profitability.

As an aside, variations of a classic butterfly do exist. Two commonly encountered variants are an iron butterfly and a broken wing butterfly.  The iron butterfly is a credit trade and is constructed using both puts and calls. 

The broken wing butterfly is built by buying the long options at different distances from the central body.

To return to our current situation in CMI, I chose a put butterfly using the 90/100/110 strike prices in the January series. I chose January because December expiration is only a few days away, and butterflies work best when given a bit of duration. 

Had weekly options been available for this underlying, I likely would have chosen to use them in order to tailor the time frame a bit shorter to allow a faster response to changes in P&L.

The P&L graph of this put butterfly is presented below.


Click to enlarge

Pay particular attention to the intermediate time curves indicated by the two broken lines in relation to the expiration curve indicated by the solid blue line. The broken lines represent the P&L today (the lower broken line) and halfway to expiration (the higher broken line). Note that the butterfly only reaches its maximum profitability at expiration.

Another characteristic is the difference in slope of the intermediate and expiration lines. While the intermediate time frames react gently to changes in price, the pace of reaction to price change increases dramatically as expiration approaches.

It is for this reason that many option traders routinely close their butterfly positions ahead of expiration. Most experienced butterfly traders do not allow their positions to go to expiration because of the position risk with adverse price moves.

Editor's Note: JW Jones offers more content at OptionsTradingSignals.com.

No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.