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

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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.

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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.
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No positions in stocks mentioned.
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