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Options Jive

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The "Free Butterfly" Effect

Options Jive

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Ratio Spreads may sometimes provide an opportunity to traders that they were not looking for initially. It’s a good example of the importance of market awareness. Movement in the underlying, the passage of time and/or in Implied Volatility (IV) may mean a trader can turn a ratio spread into a “free” Butterfly Spread. What does it mean that there is a “free” Butterfly and how and why would we choose to employ this strategy?

You may have heard Tom and Tony say, “We bought an OTM wing so now we have a free Butterfly.” It may sound confusing but it’s really quite simple. It starts with a 1 x 2 Credit Ratio Spread. An example of a Ratio Spread in XYZ stock trading at $100 was displayed. The example showed buying 1 of the $95 puts and selling 2 of the $90 puts for a net credit of 0.10. If XYZ stock is above $95 at expiration the Ratio Spread will have a $10 profit. Should the opportunity arise to buy the $85 put for 0.10 or less then the Ratio Spread would turn into a Butterfly Spread and the cost would be zero (or better) and hence the Butterfly would be “free”. Another way to think of the this Ratio Spread is as a Debit Put Vertical Spread combined with a Short Naked Put. Buying the other Put makes this a Debit Vertical spread combined with a Credit Vertical Spread. There is no risk and should the underlying be around $90 at expiration we have a much larger winner with no concern about losing money to the downside.

A graph of the SPY (S&P 500 ETF) was shown. The time period covered was from Mid January of 2016 to Mid February. It was noted that a 1x2 Put Ratio Spread of long one $183 put and short two $180 puts for a net credit of $2.26 had been established on January 20, 2016 when the SPY was trading at $185.65. By Jan 22, 2016 SPY had moved up to $190.52 The Feb 177 Put was trading for $1.06. Buying the 177 put means owning the 177/180/183 Put Butterfly for a $1.20 Credit. There is now no longer any upside or downside risk and maximum profit will occur if the SPY would be at $183 at expiration. Additionally, the margin changes to reflect the lack of risk which frees up capital to be used on other trades and allowing us to increase our number of occurrences.

For more on Ratio Spreads see:

Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the important takeaways and a better understanding of trading Credit Ratio Spreads and how they can be turned into a free Butterfly Spread.

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