XS
SM
MD
LG
XL

Ask Trader Guy: Butterfly Spread Woes and Option Arbitrage

Our resident guru explains the deal with short-term butterflies, hard-to-borrow stocks, and (ahem) “cleansing” techniques.

Print
https://tickertapecdn.tdameritrade.com/assets/images/pages/md/
2 min read

I bought a butterfly with just a few days to expiration, speculating that the stock would go to the middle strike, and it did. But the butterfly barely increased in value. What’s going on?

Think of butterflies as bets on a roulette table where there’s one “winning” butterfly at expiration. That butterfly is the one where the stock (the ball on the roulette table) lands on its middle—the short strike—at expiration. A butterfly’s value depends on the likelihood of the stock landing on the middle strike, making it the “winning” butterfly. The more time until expiration, the less certain where the stock price will land, and the lower the butterfly’s price. Close to expiration, there’s less uncertainty where the stock will land, and butterflies whose strikes are close to the stock price begin to have higher prices. It’s possible you just paid too much relative to its maximum payout value, due to buying too close to expiration.

On some stocks that are hard to borrow, I see out-of-the-money puts with really high prices. Why does that happen, and is there an arbitrage opportunity?

In order to short a stock (sell a stock that you don’t already own), you, or more specifically your brokerage and clearing firm, need to borrow it from someone that does own it. Sometimes there isn’t any stock in the market to borrow, so a stock becomes ”hard to borrow,” and therefore, you may or may not be able to short it. A trader that wants to short the stock and who can’t, might look to buy puts instead. That buying pressure on the puts drives their price up. But there isn’t any arbitrage opportunity. If you think puts are expensive the “arb” would be a reversal, selling the put, buying the call and shorting the stock. Uh-oh, you can ‘t short the stock either. You can do the first two legs of the arb, but not the third. So, no arb.

I’ve been learning more about pairs trades and have read about equalizing the notional value of the two underlying assets. What does that mean?

Notional value is the price times the dollar value of one point. For example, in the e-Mini NASDAQ future, /NQ one point equals $20. If the price of /NQ is 4,000, its notional value is $80,000. In the e-Mini S&P 500 future, / ES one point equals $50. If the price of /ES is 2,000, its notional value is $100,000. If you wanted a /ES vs. /NQ pairs trade, where the notional values were equivalent, you’d do 4 / ES futures for every 5 /NQ futures. The notional value of a stock position is simply $1, times the number of shares, times the stock price.

My nutritionist has suggested a cleanse, but I’m afraid I might become “indisposed,” if you get my drift, during the trading day. Any suggestions?

Cleanse? Kill two birds with one stone. Put on about 1,000 short gamma in expiring SPX options and don’t take your eyes off the screen until the settlement comes out. That should do the trick.

Call Us
800-454-9272

The risk of loss on a short sale is potentially unlimited since there is no limit to the price increase of a security. Equity pairs trading requires active monitoring and management and is not suitable for all investors.

Trading options involves unique risks and is not suitable for all investors. Mini-options do not reduce the per share cost or price of options.

Spreads, condors, butterflies, straddles, and other complex, multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades. Be aware that assignment on short option strategies discussed in this article could lead to unwanted long or short positions on the underlying security.

Maximum potential reward for a long put is limited by the amount that the underlying stock can fall. Should the long put position expire worthless, the entire cost of the put position would be lost.

When trading short option strategies, there is a risk in getting assigned early on the options sold, even if they go in the money by $0.01, obligating you to deliver shares you don’t own (in the case of a short call) or purchase shares (in the case of a short put).

The risk of loss on an uncovered short call option position is potentially unlimited since there is no limit to the price increase of the underlying security. Option writing as an investment strategy is absolutely inappropriate for anyone who does not fully understand the nature and extent of the risks involved.

The short naked put and cash-secured put strategies include a high risk of purchasing the corresponding stock at the strike price when the market price of the stock will likely be lower.

Short naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.

A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase. Additionally, any downside protection provided to the related stock position is limited to the premium received. (Short options can be assigned at any time up to expiration regardless of the in-the-money amount.)

adChoicesAdChoices

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.

TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.

Scroll to Top