Options strategy spreads wings

One way to gain a better understanding of how options work is to walk through how a trader—in this case, a somewhat indecisive trader—may approach a specific market situation.

Let’s say our trader noticed Ryder System (R), which hit an all-time high above $100 last month, was consolidating after pulling back close to its December–January lows. The trader decided the stock had the potential to bounce off this support level in the coming weeks:

The most basic bullish options trade would be to buy an at-the-money (ATM) call—which, shortly after Tuesday’s open, would have been an $85 call. But let’s say the trader also thought the bounce would be limited—perhaps a test of the February lows around $95. In that case the trader may decide to add a short $95 call to the long $85 call, creating a bull (vertical) call spread.

By collecting premium from the short call, the trader pays less for upside exposure, but sacrifices the (theoretically) unlimited gains of the straight long call position—potential profit is capped at the upper strike price, no matter how far the stock rallies. Yesterday morning when the stock was trading around $85.80, the May $85–$95 bull call spread was around 21% cheaper than an outright May $85 call position.

But what if the trader suddenly decides the odds of a decline to around $75 may be more likely than a bounce to $95? In that case, instead of simply buying an ATM put to capitalize on a down move, the trader could combine a long May $85 put with a short May $75 put to create a less-expensive bear put spread. In this case, the spread was around 27% cheaper than the long put, but it couldn’t continue to profit regardless of how far the stock fell below $75.

Now let’s say our trader goes full circle and decides the odds are the same for an up move or a down move. In that case, the trader could combine the bull call spread and the bear put spread, which means the total position would consist of a long May $85 call, a long May $85 put, a short May $95 call and a short May $75 call.

The result: an “iron butterfly” spread, which has the potential to profit if the stock moves higher or lower—as long as it moves enough to offset the position’s net debit (the cost of long option minus the premium collected from the short options):

Yesterday, Ryder would have needed to be trading roughly 8.5% above or below the long options’ strike price ($85) to have any profit at expiration. Also, as is the case for the vertical call and put spreads themselves, the iron butterfly’s profits are capped no matter how far the stock rallies or falls. 

As the risk-reward profile suggests, another way to think of the iron butterfly is as a long straddle (long call and put with same strike price and expiration) with limited profit potential. Again, the advantage is that the butterfly costs less to establish. In this case, the long May $75-$85-$95 iron butterfly was around 23% less expensive than the long May $85 straddle.

Of course, cost is only one part of a trade decision—after all, a strategy that is less expensive to execute won’t have much value if the odds of it succeeding are very low. Traders must always weigh a strategy’s advantages and limitations against their market outlook and goals.

Market Mover Update: Amylyx Pharmaceuticals (AMLX) closed flat yesterday after rallying 5.9% on Monday (see “Call positions grow as stock slides”).

Today’s numbers include (all times ET): Mortgage applications (7 a.m.), Pending Home Sales Index (10 a.m.), EIA Petroleum Status Report (10:30 a.m.), Survey of Business Uncertainty (11 a.m.).

Today’s earnings include: Cintas (CTAS), Paychex (PAYX), RH.com (RH), Verint (VRNT).

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