$2.50. In the real world, you’d also tack on
transaction costs. The risk graph (Figure 1)
reveals that this fly hits its max profit if the
stock settles at the body—short strike—at
market close on expiration date.
On the other hand, if the stock moves
away from the short strike in either direction, the trade would show less profit.
It would likely break even eventually, or
possibly reach a total loss if the stock price
moves to or past the wings.
Long calendars, on the other hand, use
just one strike, but spread the options between two different expiration periods.
Going back to Table 1, you might buy the
November 145 call and sell the October 145
call, for a net price of $1 ($3 – $2). The risk
graph in Figure 2 tells a similar tale: max
profit if the stock settles at the short strike
at expiration, with less profit as the stock
moves away from the strike, eventually
reaching a full loss if the stock moves far
enough away in either direction.
Since both strategies profit if the stock
is near the short strike at expiration, why
would you choose one over the other? In a
WHAT’S VOL GOT TO DO WITH I T?
Calendars and butterflies look similar on
the risk graph. And their greeks are also
similar. With the stock sitting near the
short strike, calendars and butterflies will
both be close to delta-neutral, with short
gamma and long theta. Keep in mind that
theta indicates the profit as time passes. But TRADER
for many option
traders is to try
to profit from
the passage of
like iron condors and short vertical spreads
spring to mind, for example. But two other
strategies traders could turn to are the long
calendar and long butterfly.
If you looked at the risk graph of each
strategy, you might think they’re twins. Both
trades profit if the stock is near the short
strike at expiration. And both lose value as
the stock moves away from the short strike,
regardless of direction (See Figures 1 & 2).
But dig a little deeper, and you’ll see
there’s a difference between the two. It’s
not obvious from the risk graph. But your
choice could potentially have a big impact
on how the trade performs.
FLY OR CALENDAR?
Butterflies and calendars can be created
using either all call options or all put op-
tions. You can also do a little call/put “mix
and match” to arrive at
these strategies. But let’s
keep it simple. We’ll consid-
er these strategies using all
call options, and focus on
the long version of both.
The long butterfly (or
“fly”) uses three strike prices in the same expiration.
It’s created on a 1:2:1 ratio, where the strikes
are the same distance apart. The single
options on the outside of the fly are long
options, or the wings. And the two options
in the middle are short options—they make
up the body. Get the visual now?
Using the theoretical prices in Table
1, and with the stock trading at $145, you
could buy the 140/145/150 call butterfly,
that is, buy one 140 call, sell two 145 calls,
Vega isn’t vol. But the two are related.
Suppose a stock is suddenly expected to
have a larger range than was previously
thought. The option’s implied vol could in-
crease to reflect the stock’s bigger expected
range. And that means option prices could
But just how much an option price goes
up will depend on the option’s vega—
defined as “the dollar amount an option
will change when the implied volatility
changes by one percentage point.” In other
words, if implied vol increases, the option
will increase by vega’s amount. And if implied vol drops, the option price will drop
by vega’s amount.
Here’s an example. Going back to the
theoretical values in Table 1, the November 145 call is worth $3.00 and has a vega
of 0.25. If vol jumps two points (all things
being equal) from 16% to 18%, the call is
expected to increase by $0.50 (0.25 x 2 =
$0.50). It also works in the other direction.
If vol drops by three points, and goes from
16% to 13%, this call will then be expected
to drop by $0.75, from $3.00 to $2.25 (0.25 x
- 3 = -$0.75).
If the single option changes price, will
spreads change price? It depends. But you
can also use vega to forecast what happens
to spread prices if vol changes. For spreads
that have all their options in one month,
like the fly, it’s as straightforward as adding
up the vegas for each option to arrive at
STOCK = $145 CALL OPTION
Implied volatility = 17%
October 140 $6.00 0.12
October 145 $2.00 0.15
October 150 $0.50 0.12
Implied volatility = 16%
November 140 $6.60 0.24
November 145 $3.00 0.25
November 150 $1.20 0.24
TABLE 1: Theoretical
call option and vega
values. With a hypothetical stock at $145,
these are the theoretical prices and vega
values for the given
strikes and expirations.
For illustrative purposes only.