GLD skip-strike butterfly in APR

Yesterday we were filled on a three lot of long skip-strike call butterflies in GLD, the gold ETF. Our strikes are 99/100/103.

This butterfly gave us a CREDIT of $0.40 per contract, which is counter-intuitive given that we are long the butterfly. Butterflies are normally purchased for a small amount and act like little lottery tickets. If the underlying settles near the middle where the short strikes reside, the profit potential is pretty cool, given a small investment.

Here’s how a butterfly is constructed. First, it’s all like options, meaning all calls or all puts. Once you start mixing them up you end up with an iron butterfly or a gut butterfly. We’ll leave that for another day. For now, we focus on the simple butterfly.

Alright. Like options. Let’s choose calls for now. Next, we choose equidistant strikes between three strikes in the same month. In GLD let’s choose the 99, 100, 101 strikes. They’re all one dollar apart. We can write this as a long GLD call butterfly 99/100(2)/101.

The body of the butterfly is the middle strike and it will have double the amount of contracts as the outside strikes. We collect premium from the body so we are short the inside strikes. In our example we would be short the 100 call (two times).

The wings of the butterfly are the outside strikes and they are long options. In our example, we would be long the 99 call and long the 101 call.

The body of the butterfly almost pays for the wings, but not quite. There is usually a debit of around $0.10 per contract. In an ideal scenario, GLD settles at exactly 100 at expiration. You can see that your long 99 option is worth $1.00, your two short 100 options are worthless, and your long 101 call is worthless. Your profit is $1.00 for a $0.10 investment. Not bad.

But remember, we are talking lottery tickets here, so the odds are not in your favor. But for 10 cents … why not? You only risk what you paid for it since your short strikes are beautifully hedged by your long wings. It may be worth a shot.

What would be better, though, is if you can hold a butterfly not for a debit, but for a credit. This involves some fancy footwork, but not too fancy. Basically, if you want a credit you need to take on some risk. A typical butterfly has little risk (remember, what you paid for it only). But if you adjust the strikes, you can receive a credit for your risk.

Adjusting the strikes means tweaking the equidistant concept of your typical buttefly. Let’s stick with our two short calls at 100 in GLD and start tweaking the wings. If we move the lower call lower to say 98 and leave the others we end up with a 98/100(2)/101 call butterfly. There is no credit here though, because your profit window increased.

Not sure why? Split up the butterfly into two spreads and you’ll see. You have a long 98/100 call vertical and a short 100/101 call vertical. The long spread can make $2.00 and the short spread can lose only $1.00. Nobody is gonna give you this trade for a credit.

So how do we get a credit? We take on some risk and spread out the upside call. For the actual trade we made, we spread it out by two strikes to create the 99/100(2)/103 call butterfly. Splitting it into two verticals we can see we are long the 99/100 call spread and short the 100/103 call spread. The most we can make on the long vertical is now $1.00 and the most we can lose on the short spread is now $3.00. The good news is that before we start losing money on the short vertical, we’ve maximized our credit on the long vertical. Essentially, we are now risking $2.00 for this butterfly.

Well, if we’re gonna risk $2.00, we better get a credit for our exposure to risk. And sure enough, we do. We received $0.40 for the 99/100/103 butterfly, which brings our risk down to $1.60 per butterfly.

Here’s the secret to transforming our risk into no risk. If you’ve waited this long to find out you’ve earned it. Now mind you, GLD has to initially move away from our short strike (100) for this to work but that is our general opinion of what’s happening in gold. A little pullback is likely. Should that happen, we have a chance to take our risk off the table. Remember, our risk is the 100/103 call vertical.

The 100/103 short call vertical is short the 100 strike and long the 103 strike. What we want to do is buy back the embedded 101/103 call vertical hiding in there for less than the credit we initially got ($0.40). If we are buying the 101/103 call spread, we are long 101 and short 103. By buying this spread, we cancel out our position at the 103 strike and initiate a long position at the 101 strike. The result being our 100/103 short call spread becomes a 100/101 short call spread.

Remember we did not futz around with the 99/100 vertical. We simply changed the 100/103 into a 100/101 spread. Adding them together we get the 99/100(2)/101 butterfly.

Ah, finally.

For this trade to work, GLD needs to sell off a bit so we can buy that transformational 101/103 call spread for less than the $0.40 we got credited, thereby creating a risk-free butterfly for credit.

We put this trade on yesterday and today the transformational 101/103 call spread is marked at $0.43. So, we’ll wait it out. We have 58 days to APR expiration.


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