Why We Purchase Cheap Protection For Iron Butterflies

September 23, 2019 posted by

Hey everyone. This is Kirk here again from Option Alpha
and welcome back to the video update for Wednesday, April 17th. I’m going to go over all the trades that
we made on Wednesday, as well as the single closing trade we had on Tuesday. As always, if you’re new to Option Alpha,
if we have a single closing trade on a day, we’ll just cover it in the next video update. Tuesday this week, we just had one quick close
of XLP. This was our call spread side of our iron
butterfly in XLP. If you go back through the videos, what we
did in XLP was actually, we did a little bit of an unbalanced iron butterfly. The put side was much wider than the call
side, so our payoff diagram kind of looked like this. And we did this on purpose because the call
side skew at the time was very small and that we could buy these 56 calls at the time for
really, really cheap amount, $.5, $.6, something like that and get a lot of cheap protection,
just $2 wide. Ultimately, this means much less risk on the
top side if the stock continues to move higher. Well, today, the stock did continue to move
higher and there’s no opportunity to close or to roll for a credit, so we just had to
close it for a $156 loss on Tuesday. Alright, so Wednesday, April 17th, we ended
up closing out for our GLD position, just the single two put contracts that we were
short that were in the money. If you go back again trough the video updates,
we only got assigned one of the 127 short put contracts for April, so we’re left now
with 100 shares of long stock. All of the other contracts that we have for
GLD will basically expire out of the money and worthless. There’s no need to close anything else,
other than the in the money put options that you had. Everything else, like I said, will expire
out of the money. If the 119s end up going in the money, we’ll
close those for a little bit of an extra profit. But otherwise, everything else is just going
to remain kind of on the books to be closed out. Like I said, for us, this is an easy one for
us to close because we can just remove the rest of the position. Since this is kind of blended now and we’re
still left with stock, we’re not going to total up the profit and loss until we finish
up dealing with the stock. From our perspective on dealing with the stock,
we’ve had GLD in a little bit of a down move. We’re starting to show a little bit of the
technical bull signal here for this thing. Not to say that it’s obviously going to
bottom or not, but look. I mean, it has these general ebbs and flows
where it kind of moves in these cycles and I think potentially, we’re at a little bit
of a down move that we could get a pop up. For us, we’re going to ride out our 100
shares. I have no problem holding 100 shares of long
stock and continuing to sell covered calls against it. If we do sell covered calls this week and
start that process, we’ll probably look towards something around a 20 to 25 Delta
or so and that will be for May contracts which are about 30 days out from expiration. Our Thinkorswim platform is freezing up. I would show you, but it’s about 20, 25
days or 30 days or so till expiration. Alright, so SMH. SMH, this is one of those positions that we
rolled for a credit last month. This was a good position for us. And we had it on the books for two months
now. Ultimately, the stock just continued to rise
against our position and we never had a chance to roll this thing, so massive, massive move
in SMH. This original position was entered around
93. That was the short strike right in here, kind
of the 93. And so, it rallied up against us. Last month, we had an opportunity to roll
for a credit. That was good. That reduced risk. But ultimately, the stock basically just shot
to the moon and there’s nothing we could do about it. To me, this is why in these markets, doing
a defined risk spread like an iron butterfly, even though we took a $768 loss which is nothing
for our account size, this really protected us having the long options in place to kind
of counterbalance that. If you look at the value of this long call
option at 103, I mean, this thing, we got on for $.15, $.20 or so, something like that
and ultimately, gave us a ton of risk protection for nothing originally. This is why I like, during these low implied
volatility markets, to trade these iron butterflies because if we can enter some of these positions
for small, small, small credits on the outside wings, it’s basically like trading a straddle
with protection and in environments like this where we start to see the stock continue to
just shoot to the moon or go sideways or have a black swan event and crash, we get protection
on that move. It would’ve been very, very risky for us
to do the undefined position on this trade. Alright, so new positions today, we added
two new ones. While everything else was kind of trading
generally sideways, we’ve started to see a little bit of action in IYR and XLV. IYR actually has had a little bit of movement
the last couple of days and has taken out pretty much a month worth of gains in the
last two days. As a result, implied volatility has popped
a little bit, so you can see it down here on the bottom of the chart and in that regard,
we’re going to start selling some premium. I don’t know where the end of this is going
to be. It could be somewhere around 84. It could obviously continue to fall. But in either case, implied volatility is
high now, so we’re going to start selling some premium. Today, we did a very tight iron condor. Yes, it is an iron condor because we sold
the 86 call and the 85 put option. In this case, were doing this just a $1 wide
iron condor. It very much acts like an iron butterfly. It’s just a very, very small kind of flat
peak there on the payoff diagram. It’s going to act more like an iron butterfly
than anything else. And then we decided to go out on either end
and again, buy really cheap protection. This is what we talk about. Even though implied volatility is starting
to rise a little bit, we can still buy some cheap protection. And look at the call side. I mean, the call side is $.4. Even though implied volatility is starting
to rise, it’s getting higher, it’s not insanely high yet, we can still buy this cheap
protection for pennies on the dollar in case this thing kind of turns back around against
us. Again, this is our first position in IYR,
definitely plan to ladder into more. Same thing with XLV. XLV got absolutely annihilated the last couple
of days. I mean, literally, if you blinked, this thing
basically turned back around. This is also a wonderful case study in just
letting trades go pretty much close to expiration or in the last week of expiration. You look at this trade and say you had a position
at 85 that you’ve been holding onto for a long time, an iron butterfly at 85 or 86,
man, this thing looked like a sore loser for three months and then in the literally two
days, it comes back around. This is why I tell people all the time, we’re
big fans of trying to hold these things just as deep as we possibly can. Now that we’re in the last couple of days
of expirations, it’s obviously much harder to hold these and avoid the risk of assignment. But this is why we do this, because we get
these last minute moves during expiration week that sometimes can be massive. I mean, none of the rest of the markets are
moving like this and XLV is in many cases, highly correlated to the S&P and to the Qs
and to the DOW. None of those things are moving as much as
this thing is. Healthcare is getting rocked right now and
as a result, implied volatility is very, very high and actually starting to go higher. We’ll see where this goes in the next couple
of days. Still for us though, even though implied volatility
is starting to creep up, these option premiums on the outside ends are pretty cheap. For us, we could sell the 86 at the money
iron butterfly and still go about $6 out on either end and buy some pretty cheap protection. On the put side, we went out about $7 on the
put side. On the call side, we went out about $6 and
still bought some really, really cheap protection because I don’t think it’s done yet. I think there’s a lot of movements still
in XLV, but regardless, wherever it goes, we’re still going to get some premium. For us, we collected a very nice, fat premium
for 30 days to go till expiration, $3.18. That basically gives us about a $6 range for
this thing to be trading in, so a pretty nice wide range for this thing from where it’s
at right now, so again, a good trade, in my opinion and a first good entry. Hopefully this helps out. As always, if you have any questions, let
me know and until next time, happy trading.

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