In my morning email today, I highlighted a large trade in Anadarko Petroleum (APC). This trade is referred to in the options trading world as a butterfly. Here are the details of the trade:
Buy 16,500 January 95 Calls (exp. 2016) for $5.25,
Sell 33,000 January 120 Calls (exp. 2016) for $1.60,
Buy 16,500 January 145 Calls (exp. 2016) for $0.60.
The total net cost of the trade was $2.65 per spread or $4,372,500 for the entire trade. That premium is the most the trader can lose on this trade.
We have not executed a butterfly yet but I’m sure we will at some point. Therefore, I thought I would break this trade down so that you can become familiar with the strategy.
At the time of the trade, APC was trading at 78.50, having recently fallen hard with the rest of the oil sector. This is a bullish trade as the delta on each part of this trade is the following:
January 95 Calls - 35 delta - 16,500 times = 577,500 positive delta
January 120 Calls - 14 delta - 33,000 times = 462,000 negative delta
January 145 Calls - 6 delta - 16,500 times = 99,000 positive delta
Net, a positive, or long, delta of 214,500 delta.
So why execute a butterfly vs. another other bullish strategy?
In this case, I assume the trader, while bullish, wants to limit his premium exposure. He accomplishes this by selling twice as many 120 calls as 95 calls and 145 calls.
When trading a butterfly, typically a trader buys one option, sells two options, and then buys another option. That is exactly what the trader did in this APC trade, though clearly in much larger quantities.
Also typical in butterfly trades, the trader keeps the distance between strikes identical. For example, in this trade there was $25 between the 95 and 120 strike ... and $25 between the 120 and 145 strike. By keeping the ratio at 1x2x1 (or some multiple of that) and the distance between the strikes of similar distance, the most the trader can lose on the trade is the premium spent.
So why purchase a butterfly versus the January 95/120 Bull Call Spread?
If the trader had just bought the January 95/120 Bull Call Spread, his premium outlay would have been $3.65 per spread versus $2.65 for the butterfly. So the butterfly is a lower-cost trade.
Selling two of the 120 calls helps to lower the cost of the trade. However, if the trader was simply long one of the 95 calls and short two of the 120 calls, he would have unlimited upside risk. That’s why he must buy the 145 calls to cap his upside risk.
Here’s a basic graph of the profit and loss of this strategy on the spread’s expiration:
As you can see, the ideal spot on expiration for this trade is at 120. At that level, the trader would make $36,877,500 on this position. This is because the 95 calls would appreciate in value until 120. At 120, the short calls would take the trader out of his long position. Then, if the stock continued to go higher, the trader would be net short calls as the second call he sold at 120 would now make him short until 145. At 145, the trader’s net position would be flat.
There are plusses and minuses to butterfly trades.
I like butterfly trades as they reduce capital at risk.
I don’t like butterfly trades as you typically need to “thread the needle,” i.e., in this case, the trader needs the stock to be above 95, but not above 145. (This is actually a very wide range so there isn’t a “thread the needle” scenario.)
In the case of this trade I do like the risk/reward. The most the trader can lose is $4,372,500 ($2.65 per spread)--a small sum to risk with such great upside if the stock closes between the fairly large range of 95 and 145.
In light of the recent oil stock rout, I expect this trade’s challenge to profitability will be getting APC back above 95. Along the same lines, 145 and above at this time seems very unlikely so that would not be a major concern when evaluating this trade’s risk.
In conclusion, I really like the risk/reward of this trade. Yet clearly, if APC remains at the current levels, this trade will lose its full premium.