SMB’s Options Training Program Presents:

The Heart Friendly Butterfly

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Disclaimer

Please note: Hypothetical computer simulated performance results are believed to be accurately presented. However, they are not guaranteed as to accuracy or completeness and are subject to change without any notice. Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Since, also, the trades have not actually been executed; the results may have been under or over compensated for the impact, if any, of certain market factors such as liquidity, slippage and commissions. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any portfolio will, or is likely to achieve profits or losses similar to those shown. All investments and trades carry risks.”

Hypothetical Trades Disclaimer

HEART FRIENDLY BUTTERFLY FUNDAMENTALS

PART 1

Question: What’s so heart friendly about the heart friendly butterfly?

The Heart Friendly Butterfly

Deltas are heavily under control throughout the trade.

The maximum permitted loss is very mild—10% of planned capital.

Performs well in most kinds of markets—channeling, reasonable uptrends, reasonable downtrends, reasonable whipsaws.

The trade design is simple and intuitive.

Answer: You rarely feel stressed out

The Double Butterfly: The Original Ancestor of the HFB

What’s a double butterfly?

Iron Butterfly at Inception

Breakevens about 70 points apart

Typical Trade Plan for Double Butterfly

Analyze graph after adjustment

If the market moves too quickly to the upside the trade’s P and L can be down substantially at the adjustment point.

The Problem…………………

August, 2009 double butterfly

With the HFB technique we scale into the upside butterfly

..with greater theta and lower delta to boot

We’re chillin’…………………..

…..like a villain

We enter the trade 36 days out from options expiration.

Good idea to wait until 10:30 Eastern Time to let the market settle down and clear out any reaction to news events and economic reports that were earlier reported.

Observe the At-The-Money call of the expiration that you are trading.

If it is greater than 30%, then do not enter the trade for that month. These are extreme market conditions not favorable to this trade.

Heart Friendly Butterfly Trade Initiation

Wait for the market to get within 5 points a 25 point strike on the $SPX (best liquidity)

Measure a 29 day one standard deviation move on the $SPX from that strike.

Round down to the nearest 25 point strike. Then sell an iron butterfly with the short strikes at the

money and the long strikes at the 25 point strike arrived at through the above standard deviation analysis.

Minimum Two Lots No less than 50 point wings and no greater than 75

points.

If the ATM Call is less than 30%

Planned Capital is a function of wing width.

If the implied volatilities call for the iron butterfly to have 50 point wings, then the planned capital is $7,500 per unit.

If the implied volatilities call for the iron butterfly to have 75 point wings, then the planned capital is $11,250 per unit.

Planned Capital

The Profit target is set at 50% of the peak of profitability at seven days before expiration according to your analytical software.

So there is no fixed percentage target profit. It is a floating number based upon market conditions and the exact number of adjustments, realized gains and realized losses embedded in the trade at any one time.

The maximum loss on the other hand equals 10% of planned capital at all times, thus $750 per unit for 50 point wing trades and $1,125 per unit for 75 point wing trades.

Profit Target and Maximum Loss

…So for example

Trade Initiation of the HFB

There is one initial downside adjustment point which is simply the expiration day breakeven on the downside.

There are two initial upside adjustment points they are: 50% between the short strike and upside expiration day breakeven AND the upside expiration day breakeven itself.

In other words, the upside adjustment plan is more aggressive than the downside plan.

Adjustment Points

Adjustment Points

Initial Downside Adjustment: Buy a put side butterfly, the same number of lots as the original iron butterfly, transforming the position into an iron condor.

Initial Upside Adjustments: Buy a half-lot call side butterfly halfway between the short strikes of the original iron butterfly and the original expiration day breakeven. If the market trends upward further, buy a second half lot butterfly at the original short strikes of the original iron butterfly completing the transformation of the position into an iron condor.

Adjustment Process

First Upside Adjustment

Analyze Graph after adjustment

So the downside adjustment is a single full “condorization” of the iron butterfly, whereas the upside adjustment, culminating in a full condorization, happens in two stages. This is because of the negative delta nature of iron butterflies, at the money, initiated five weeks before expiration. The upside risk must be controlled more quickly than the downside risk.

Note that one of the long strikes of the adjusting butterflies always sits on top of the original iron butterfly short strikes and the short strikes of the adjusting butterflies sit on top of the original iron butterfly of the long strikes.

Adjustment Butterflies

Second Upside Adjustment

Post Adjustment—an iron condor

Iron Condor—the widened tent

Should the market continue trending in the direction of the new short strike, implement a 25 point roll of the credit spread under attack to buy additional space for the market to trend before rest or reversing.

Further Trending Adjustment

The condor roll

The widened condor

25 points of extra runway

The Last Stand

We roll the profitable short strike to the market but roll its associated long up 25 points less, creating a wider credit spread on the profitable side of the trade.

Simultaneously we roll the long of the attacked credit spread out 25 points further.

This creates an iron butterfly with 25 point wider wings than the original trade.

If the market trends even further…..

Rolling the Position into a Wider Iron Butterfly

A new iron butterfly

The new iron butterfly flattens delta and boosts theta

At this final do-or-die point in the trade, we simply revert to the original trade rules.

Apply a butterfly adjustment, condorizing the trade, at the downside breakeven point.

Phase into an upside condor in two adjustments as per the original trade procedures.

Final Trade Position Adjustment Plan

Return to Profitability

$4,441 profit showing two days before expiration which is…….

…target profit.

How to handle market whipsaws. Examples of the HFB in extreme market

moves. Examples of the HFB in flat, channeling

markets. Scaling out of the trade and milking it for

more profit.

Coming Attractions