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2013/08/20 Introduction to the Weekly Short Butterfly

Jeff Augen 2013/08/20

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Unusual Dynamics of the Weekly Options Market


Weekly options are heavily traded and have enormous open interest Dwarfing most other option series

Large numbers of investors aggressively selling time decay have depressed prices and created unusual distortions
These distortions can be profitably traded The dynamics are complex and simple approaches to trading weekly options that worked just one year ago have become obsolete High levels of weekly option activity distort the VIX calculation which never includes weekly options SPX options used for the VIX calculation represent a tiny percentage of the total number of contracts traded on the S&P 500 Option pricing theory dramatically underprices volatility in short time frames. Over the past 100 days, NFLX averaged a unique strike cross every 312 minutes; AAPL averaged a unique cross every 234 minutes. Their respective ATM implied volatilities are 37% and 28%.
AAPL Strike (8/23 weekly) Calls Open Int. Puts Open Int. 465 1,804 1,929 470 2,444 2,129 475 2,340 3,606 480 3,004 3,284 485 2,420 1,907 490 2,373 2,165 495 3,966 1,809 500 6,250 1,811 505 5,981 391 510 4,146 349 515 6,464 180 520 2,553 46 525 1,429 72 530 1,968 12 535 1,082 64 540 1,147 81 49,371 total 19,835 69,206 SPX Strike (8/23 Weekly) 1620 1625 1630 1635 1640 1645 1650 1655 1660 1665 1670 1675 1680 1685 1690 1695 Calls Open Int. Puts Open Int. 18 2,148 10 17,109 13 3,638 7 1,344 31 7,274 29 3,136 88 14,279 92 5,828 700 4,591 1,316 820 753 3,044 5,560 8,589 2,625 2,346 1,347 1,152 4,532 2,784 1,971 833 19092 78,915 98,007

Short butterflies are margin-friendly, low risk, high return trades that tend to be profitable in many different timeframes. They can generate a profit from rising implied volatility or a modest move of the underlying stock. A typical trade might be composed of:

10 short $100 calls 20 long $110 calls 10 short $120 calls


For a net credit.
Maximum profit of the trade is equal to the credit

Although certain timeframes should be avoided (Thursday with 1 day remaining before expiration or the final weekend), timing is less critical than it is for long butterflies.
Wider spacing between the strikes makes the trade more sensitive to movement of the underlying stock but also increases time decay cost. Adjusting strike spacing makes it possible to place profitable trades in almost any timeframe. One of the most profitable times for a short butterfly is in the final hour before expiration when the credit is excessively large and virtually any move of the stock generates a profit.

The following data was gathered at the close on Friday 8/16 for options expiring in 7 days. $10 spaced butterfly had a $2 credit and a $10 move in either direction generates a substantial profit even though we are at the beginning of the weekly trading window.

$10 Spaced Strikes 475 / 485 / 495 480 / 490 / 500 485 / 495 / 505 490 / 500 / 510 495 / 505 / 515 500 / 510 / 520 505 / 515 / 525 510 / 520/ 530 515 / 525/ 535

Midpoint($) Credit -0.70 -1.45 -1.60 -1.90 -2.00 -1.94 -1.40 -1.16 -0.78

$10 move up or down generates a substantial profit. Time decay is $0.097/day. This value will accelerate during the week as the position credit and sensitivity to movement also increases.

AAPL $10 spaced short butterfly prices with 7 days remaining before expiration.

Stock @ 503.10

Friday is one of the best days to trade a short butterfly. The distortion is greatest in the final 30 minutes when the credit for a $5 spaced trade approaches $5.00. The table on the left lists average open to close price changes for AAPL during the final 30 minutes and final 15 minutes (25 expirations). The table on the right lists average high-low transitions for the same timeframes. It is clear that $5 spaced short butterflies are profitable even during the final few minutes of trading because credits larger than $4 are common (i.e. a $1 move is profitable).

Date 09/07/2012 09/14/2012 09/21/2012 09/28/2012 10/05/2012 10/12/2012 10/19/2012 10/26/2012 11/02/2012 11/09/2012 11/16/2012 11/30/2012 12/07/2012 12/14/2012 12/21/2012 12/28/2012 01/04/2013 01/11/2013 01/18/2013 01/25/2013 02/01/2013 02/08/2013 02/15/2013 02/22/2013 03/01/2013

Final 30 Final 15 Final 30 Final 15 Final 30 Final 15 minutes minutes AbsValue AbsValue Avg Chng Avg Chng 0.14 0.16 0.14 0.16 2.01 1.87 -1.55 -0.41 1.55 0.41 -1.43 0.02 1.43 0.02 -3.15 -2.70 3.15 2.70 -1.43 -1.08 1.43 1.08 -0.31 -0.15 0.31 0.15 -4.26 -3.34 4.26 3.34 -5.25 -4.58 5.25 4.58 -4.71 -2.10 4.71 2.10 1.49 -0.89 1.49 0.89 3.69 1.98 3.69 1.98 1.06 1.37 1.06 1.37 -1.04 1.50 1.04 1.50 1.63 2.98 1.63 2.98 4.31 3.41 4.31 3.41 -1.82 -3.42 1.82 3.42 -2.34 -3.53 2.34 3.53 -0.46 -0.65 0.46 0.65 1.40 0.69 1.40 0.69 -4.09 -6.43 4.09 6.43 -0.14 1.48 0.14 1.48 -2.79 -1.63 2.79 1.63 -0.27 -0.15 0.27 0.15 0.70 0.38 0.70 0.38 -0.79 -1.64 0.79 1.64

Date 09/07/2012 09/14/2012 09/21/2012 09/28/2012 10/05/2012 10/12/2012 10/19/2012 10/26/2012 11/02/2012 11/09/2012 11/16/2012 11/30/2012 12/07/2012 12/14/2012 12/21/2012 12/28/2012 01/04/2013 01/11/2013 01/18/2013 01/25/2013 02/01/2013 02/08/2013 02/15/2013 02/22/2013 03/01/2013

Final 30 min Final 15 min Final 30 Avg Final 15 (H-l) (H-l) (H-L) Avg (H-L) 0.85 0.80 3.87 3.27 3.12 2.10 2.83 2.05 4.08 2.97 3.24 2.64 1.69 1.69 4.88 4.05 6.42 6.42 7.02 4.51 4.05 3.85 5.31 3.66 2.22 1.92 4.70 4.36 4.70 4.58 4.73 3.90 6.14 5.32 4.64 4.33 1.68 1.34 1.60 0.93 10.92 10.92 3.17 2.66 3.53 2.45 1.00 0.98 1.88 1.34 2.30 2.10

The following table contains prices for last weeks $5 spaced call butterfly on NFLX. Several different timeframes are inclu ded.

Description Mon Morning Open Trade

Date/Time 2013-08-12 9:30

Days Rem. 4.27

Stock Price 250.42

Call Strike 245 250 255

Price 7.29 4.26 2.20

Credit

P&L

-970

Tues Morning Close Trade

2013-08-13 9:30

3.27

258.84

245 250 255


245 250 255 245 250 255

14.08 9.63 5.88


6.21 1.71 0.07 13.87 8.87 3.87

-700

28%

Fri Morning Open Trade

2013-08-16 9:42

0.26

251.20

-2860

Fri Final Close

2013-08-16 16:00

0.00

258.87

100%

Some of the largest profits are generated just before the close on Friday when the credit of the trade is exceptionally large and almost no time remains before expiration. At this point in the expiration cycle, option pricing theory completely fails and the market degenerates into pure gambling. Most retail traders incorrectly believe that the best opportunity for this timeframe involves selling time decay. The following example outlines prices for a NFLX short butterfly placed in the final 90 minutes before the market closed last Friday. A move smaller than $2.00 generated a 63% profit. The large credit ($3.09) would have generated a profit at any closing price above $256.91 or below $253.09 a move of just $1.91.

Description Fri Afternoon Open Trade 1.5 hrs. remaining Fri Final Close

Date/Time 2013-08-16 14:38

Days Rem. 0.06

Stock Price 256.90

Call Strike 250 255 260 250 255 260

Price 6.90 1.93 0.05 8.87 3.87 0.00

Credit

P&L

-3090

2013-08-16 16:00

0.00

258.87

-1130

63%

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