Veteran options trader Steve Smith breaks down a key strategy.
Editor's note: To help investors profitably navigate the options market, Minyanville is launching "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader and author of OptionSmith (Click here for a two-week FREE trial and get Steve's best trading ideas in real time) Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers.
Do not touch nothing. The truth will be revealed by the facts as they exist.
-- Hercule Poirot's in The Murder on the Orient Express
One of the biggest challenges in using options as an investment tool is that not only must you be right on direction and price target, but you must also be accurate in your timing. You can buy a call with too short an expiration period, watch the stock go up, and actually lose money because time decay will offset most or all of the directional gains if the move does not come quickly enough.
Butterfly spreads are a good, low-cost way to establish positions that are not impacted by time decay or short-term price movement. Due to their balanced construction, their value only becomes price sensitive -- albeit exponentially so -- as expiration approaches.
In this way, one can eliminate the need to be right about the velocity of the price move -- you need only be correct about the price level at expiration. This makes butterfly spreads useful as both protective positions and potentially highly profitable directional bets.
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