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Late Trade: Calendar vs Butterfly

by Uncle Bob Williams

AAPL Calendar spread vs. Butterfly spread - what happens too close to expiration.

Two of the Options trader's key strategy tools are Calendar spreads and Butterfly spreads. Under most circumstances, these spreads are entered anywhere from 25 to 35 days prior to expiration. Enter earlier than 35 days and you take the risk of the underlying price moving too much without gaining Theta - which is where the profits come from. Enter too late and you'll end up with a very narrow position with a higher risk of price movement loss. 

We decided to test the limits of these two strategies by placing trades closer to the expiration than the 'normal' range. With only 17 days before expiration, we entered a Calendar and Butterfly spread at the same time to watch and compare these 2 strategies.

These trades have expired. This is an informative example.

=> Open Trade | AAPL | Calendar spread | August Expiration

This trade was too close to the expiration. This is only a learning example.

Sell 1 Contract | AAPL | August 2012 Expiration | 595 | Put 
Buy 1 Contract | AAPL | September 2012 Expiration | 595 | Put 
Spread Price: $9.15 Debit

(There is no maintenance requirement on a Calendar spread, the maximum loss is the amount you pay.)
14 Day Yield: 33.5%

Index at purchase: $596.77
Days until Expiration: 17

- - - -

Open Trade  | AAPL | Butterfly spread |August Expiration

Buy 1 Contract | AAPL | August 2012 Expiration | 565 | Put 
Sell 2 Contracts | AAPL | August 2012 Expiration | 595 | Put 
Buy 1 Contract | AAPL | August 2012 Expiration | 625 | Put 
Spread Price: $11.98 Debit

(There is no maintenance requirement on a Butterfly spread, the maximum loss is the amount you pay.)
14 Day Yield: 45.7%

Index at purchase: $597.00
Days until Expiration: 17

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After 3 Trade Days | A few days into the trade and interesting things are happening.

The Calendar spread is showing a healthy Profit: 7.65%

The Butterfly spread is showing a small Loss: -2.88%

Before we dive into the analysis, please look at the Trade Monitor screen shot below - you may need to click on the image to enlarge it. (We expanded the "Positions Details" section so you can see relevant details)

Calendar Spread Analysis:

=> The underlying price moved higher than our Short strike, but well within our profitability zone. (Note that the Break-even point on the Calendar: 617, is further out than the Break Even point on the Butterfly: 613.)

Result: Price Movement was OK.

=> The IV has risen slightly since we placed this trade: Up 2 points on our Long Strike - almost a 10% increase, vs. Up 1 point on our Short Strike. Rising IV is good for Calendar spreads. In this case our Short Strike decreased in value as anticipated with the Time Decay (Theta), and our Long Strike increased in value with the rising IV. The result of both changes is a healthy 7.65% Profit after only 3 days.

The Theta / Time Decay increases as we get closer to expiration. see Theta graph When the Theta increases, it means that with each day that passes, the price of our Option will drop faster and faster. So naturally, our Short Strike which is closer to expiration will get cheaper and cheaper the closer we get to expiration where as our Long Strike will not drop in value as fast because of the extra time until expiration.

Result: Rising IV made this spread profitable.

** Trade Rule: Rising IV is Good for Calendar spreads.

- - - -

Butterfly Spread Analysis:

=> The underlying price moved higher than our Short strike, but still within our profitability zone: however it is closer to the Break-even point than our Calendar spread.

Result: Price Movement was OK, but too much given that we have only been in the trade for 3 days and there wasn't enough Time Decay (Theta) to compensate.

=> The IV has risen slightly since we placed this trade: Rising IV is Fair to Bad for Butterfly spreads. With a Butterfly, we want the 2 Short Strikes in the middle to get cheaper to buy back. These positions are getting further Out of the Money, yet the price keeps going UP because of the increased IV! Ouch.

Result: Rising IV put this position into loss.

** Trade Rule: Rising IV is Fair to Bad for Butterfly spreads.

=> The Butterfly has a net Delta of -0.10, which means that as the price of AAPL goes up by $1, our position will drop in value by $-0.10. With Butterfly spreads, we want to be Delta Neutral, meaning that we want the net Delta to be as close to zero as possible. In this case the Short Delta is too small to make a meaningful difference to our position. The small loss we are showing is due primarily to the IV increase.

"Short Delta" means that we have a negative net Delta value. If the net Delta was positive, we would say that our position is "Long Delta".

Result: We are Short Delta, but not enough to make a difference in the profitability.

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After 5 Trade Days | The price of AAPL continues to rise, fast.

We evaluated the effects of rising IV on these positions above.

Since we opened the positions, AAPL has risen $18 (3%). The Butterfly is now past the breakeven point and we will remove this trade now. The Calendar spread is still within the breakeven point, and the position is still showing a profit, so we will keep it open in the Paper Trade.

Before we dive into the analysis, please look at the Trade Monitor screen shot below - you may need to click on the image to enlarge it.

Calendar Spread Analysis:

=> The underlying price rose $18 (3%), since we started this trade one week ago. This 'small' price movement put our positions into 'trouble' because we entered these spreads too close to expiration. If we entered the positions during the correct time period, the breakeven points would be further out which gives these positions more breathing room as the underlying price oscillates up and down.

Result: The Price Movement was bad because of the late entry which resulted in a small range of profit.

** Trade Rule: Don't enter Calendar and Butterfly spreads with less than 25 days remaining before expiration.

= = = = = = = = = = = = = = =

After 6 Trade Days | AAPL continues to rise and we are forced to remove the Calendar spread.

The price of AAPL moved above our breakeven point of 618, so we are going to remove this trade.

If this was a live trade, we would have removed it earlier and the loss would have been minimal.

= = = = = = = = = = = = = = =

In summary, this trade exercise displayed with real trades four key trading lessons for Calendar and Butterfly spreads:

=> Don't enter Calendar and Butterfly spreads with less than 25 days remaining before expiration.

=> Rising IV is Fair to Bad for Butterfly spreads.

=> Rising IV is Good for Calendar spreads.

=> Have a trading plan and exit according to your plan. As the Calendar example above showed, once the underlying went past the break-even point, which was our exit point, the losses grew very quickly.

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