Risk taken off of APR GLD butterfly

Well, it wasn’t a classic butterfly. It was a skip-strike butterfly. Or an unbalanced butterfly. Or if you prefer, a regular butterfly with an embedded short call spread.

The original trade was an APR GLD call butterfly with strikes at 99/100/103. The 100 strike is the short strike and has double the options of the outside long options. We did a 3-lot so the distribution is long 99 (3), short 100 (6) and long 103 (3). The risk of a classic butterfly is only what was paid, which is usually about $0.15 for a 1-point wide spread. Our butterfly gave us a credit of $0.40. To receive that credit, we took on more risk than a classic butterfly.

A quick explanation of the construction of a butterfly. Essentially, it is convergence of a long spread and a short spread with the convergence being the short strike. You’ll remember that you pay for long spreads, and only risk what you paid. You get a credit for a short spread, and the risk is the distance between the strikes minus credit received.

Our GLD butterfly is essentially a long 99/100 call spread and short a 100/103 call spread. It’s a risky butterfly because the potential benefit of the long spread ($1.00) is less than the potential risk of the short spread ($3.00). By assuming this risk, we received a credit of $0.40 for trade.

The idea behind the trade is to take off risk when the opportunity presents itself, and have a free lottery ticket. For that to happen, we need to pay less than $0.40 to neutralize our risk.

There are a few ways to take the risk off.

1. Purchase the 101/103 call spread.

This squeezes the short call spread to the same length as the long call spread. When we buy the 101/103 call spread, we buy the 101 and sell the 103. We don’t have a position at the 101 strike, so that will be a new long strike. We do have a long 103 call, so the spread will cancel out that position. Our resulting position is a 99/100/103 call butterfly.

2. Purchase the 97/99 call spread.

This stretches the long call spread to the same length as the short call spread. It gives us a bigger range to profit as the resulting butterfly would be the 97/100/103.

3. Buy back short options.

If we bought back all the short call options, we would be left with a long 99 call and a long 103 call. GLD settling over 99 is good, over 103 is double good. Buying back short options is normally a good practice, but we can buy back half the options and still accomplish our goal of taking off risk, and keeping a lottery ticket. Let’s think about it this way. We leave alone the short calls associated with our long spread and buy back the calls associated with our short call spread. We take out the guts of the butterfly and are left with a long call spread and an orphaned long call.

For this trade to work out as planned, GLD needs to initially trade lower and give us a chance to take off risk for less than $0.40 per butterfly, and then close above 99 by April expiration.

We chose option number 3 and BOT half our short strike options for $0.15. That gives us a credit of $0.25 for a long call spread (99/100) and an orphaned long call (103). This also generates the least in commissions since we are transacting only one strike and not two, as is the case with spreads.

Who knows what will happen in the next two weeks. In any case, we can move on to the next trade as this one has locked in a small profit and has no risk.


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