Butterflies & Wingspreads

Long Call Butterfly
Long 1 XYZ Sep 50 call @ $2.00, Short 2 XYZ Sep 55 calls @ $1.00, Long 1 XYZ Sep 60 call @ $.50
Total Cost	Option premium paid, $50
Maximum Loss	Option premium paid, $50
Maximum Profit	Dollar value of difference between outside and middle strike prices minus premium paid, $450
Short Call Butterfly:
Short 1 XYZ Sep 50 call @ $2.00, Long 2 XYZ Sep 55 calls @ $1.00, Short 1 XYZ Sep 60 call @ $.50
Total Credit Received	Net option premium received, $50
Maximum Loss	Dollar value of difference between outside and middle strike prices minus credit received, $450
Maximum Profit	Net option premium received, $50
Long Put Butterfly:
Long 1 XYZ Sep 30 put @ $.25, Short 2 XYZ Sep 35 puts @ $.50, Long 1 XYZ Sep 40 put @ $1.00
Total Cost	Option premium paid, $25
Maximum Loss	Option premium paid, $25
Maximum Profit	Dollar value of difference between outside and middle strike prices minus premium paid, $475
Short Put Butterfly
Short 1 XYZ Sep 30 put @ $.25, Long 2 XYZ Sep 35 puts @ $.50, Short 1 XYZ Sep 40 put @ $1.00
Total Credit Received	Net option premium received, $25
Maximum Loss	Dollar value of difference between outside and middle strike prices minus credit received, $475
Maximum Profit	Net option premium received, $25

Explanation and Application

Butterflies, condors and "wingspreads" are so-called because with sufficient -- no, make that CONSIDERABLE imagination, their expiration date risk profiles look like something that could fly. That, and anything that can add a bit of color to the otherwise dreary world of option trading is welcome. When talking about butterflies et al., you'll hear self-proclaimed experts speak of options as "body" and "wings". The "body" refers to options with strikes in between the two exoskeletal outermost strikes. The "wings" refer to options at the diaphanous outermost strikes. We use the term "wingspreads" to identify option positions such as "condors", "pterodactyls" and "albatrosses", which look like butterflies that have been stretched out. Rather than come up with a myriad of names to identify these spreads, we use "wingspreads" because they all have similar risk/reward characteristics and sensitivities, and those flying creatures are much more threatening than butterflies.

The risks and potential rewards of butterflies and wingspreads are limited. If you buy a butterfly, the most you can lose is the amount you paid for it. The most you can make is the difference between the "body" strike and a "wing" strike minus the amount you paid for it. If you sell a butterfly, the loss and profit are the inverse of buying a butterfly.

Ratio & Back Spreads

Call Back Spread
Short 1 XYZ Sep 50 call @ $2.00, Long 2 XYZ Sep 60 calls @ $0.75
Cost	$50 Credit
Maximum Loss	$950
Maximum Profit	Unlimited
Call Ratio Spread
Long 1 XYZ Sep 50 call @ $2.00, Short 2 XYZ Sep 60 calls @ $0.75
Cost	$50 Debit
Maximum Loss	Unlimited
Maximum Profit	$950
Put Back Spread
Short 1 XYZ Sep 50 put @ $1.00, Long 2 XYZ Sep 40 puts @ $0.50
Cost	$0 Even Money
Maximum Loss	$1000
Maximum Profit	Unlimited
Put Ratio Spread:
Long 1 XYZ Sep 50 put @ $1.00, Short 2 XYZ Sep 40 puts @ $0.50
Cost	$0 Even Money
Maximum Loss	Unlimited
Maximum Profit	$1000

Explanation and Application

Back spreads and ratio spreads are simply the mirror image of each other. Back spreads and ratio spreads are comprised of either both calls or both puts at two different strike prices in the same expiration month. If the spread has more long contracts than short contracts, it is a Back Spread. If there are more short contracts, it is a Ratio Spread. Any ratio of long to short options is possible, but to keep it simple we will deal mainly with 1 by 2s in this article, i.e. long 1 option and short 2 option ratio spreads, and short 1 option and long 2 option back spreads. When naming this type of spread, the lower strike is generally stated first, whether it is long or short, so, it's the Sep 50/60 call back spread or ratio spread, and the 40/50 put back spread or ratio spread.

Back spreads and ratio spreads can be executed for debits (you pay money) or credits (you receive money) or Even Money when there is no debit or credit. This occurs because the amount you pay for the long options in the spread is sometimes less than, equal to, or more than the amount you receive for the short options in the spread. This can be a bit confusing at times, because you might be a credit bid for a back spread or ratio spread.

Straddles & Strangles

Long Straddle
Long 1 XYZ Sep 50 call @ $2.00, Long 1 XYZ Sep 50 put @ $1.75
Total Cost	Option Premium Paid, $375
Maximum Loss	Option Premium Paid, $375
Maximum Profit	Unlimited Potential
Short Straddle
Short 1 XYZ Sep 50 call @ $2.00, Short 1 XYZ Sep 50 put @ $1.75
Total Credit Received	Net option premium received, $375
Maximum Loss	Unlimited Potential
Maximum Profit	Net option premium received, $375
Long Strangle
Long 1 XYZ Sep 40 put @ $1.00, Long 1 XYZ Sep 60 call @ $.75
Total Cost	Option Premium Paid, $175
Maximum Loss	Option Premium Paid, $175
Maximum Profit	Unlimited Potential
Short Strangle
Short1 XYZ Sep 40 put @ $1.00, Short 1 XYZ Sep 60 call @ $.75
Total Credit Received	Net option premium received, $175
Maximum Loss	Unlimited Potential
Maximum Profit	Net option premium received, $175

Explanation and Application

The names "straddle" and "strangle" may give you clues about these option positions. Like your favorite politician trying to win both Democratic and Republican votes, these positions are on both sides of the issue. Long straddles and strangles make money if the stock price moves up or down significantly. Who cares which way the stock goes, so long as it GOES!

Straddles and strangles are essentially speculations on whether the price of the stock will move a lot or not or implied volatility is going to go up or down. If you think the stock is going to move big in one direction or another and/or if you think implied volatility is going to rise, you would buy a straddle or strangle. If you think the stock is going to sit still or not move very much and/or if you think implied volatility is going to fall, you would sell short a straddle or strangle.

A long straddle is long 1 call and long 1 put at the same strike price and expiration and on the same stock. A long strangle is long 1 call at a higher strike and long 1 put at a lower strike in the same expiration and on the same stock. Such a position makes money if the stock price moves up or down well past the strike prices of the strangle. Long straddles and strangles have limited risk but unlimited profit potential.

Verticals

Essentials

Long Call (Bull) Vertical
Long 1 XYZ Sep 50 call @ $2.00, Short 1 XYZ Sep 60 call @ $.75
Total Cost	Option premium paid, $125
Maximum Loss	Option premium paid, $125
Maximum Profit	Dollar value of difference between the strike prices minus premium paid, $875
Short Call (Bear) Vertical
Short 1 XYZ Sep 50 call @ $2.00, Long 1 XYZ Sep 60 call @ $.75
Total Credit Received	Net option premium received, $125
Maximum Loss	Dollar value of difference between the strike prices minus credit received, $875
Maximum Profit	Net option premium received, $125
Long Put (Bear) Vertical
Long 1 XYZ Sep 40 put @ $1.00, Short 1 XYZ Sep 35 put @ $.25
Total Cost	Option premium paid, $75
Maximum Loss	Option premium paid, $75
Maximum Profit	Dollar value of difference between the strike prices minus premium paid, $425
Short Put (Bull) Vertical
Short 1 XYZ Sep 40 put @ $1.00, Long 1 XYZ Sep 35 put @ $.25
Total Credit Received	Net option premium received, $75
Maximum Loss	Dollar value of difference between the strike prices minus credit received, $425
Maximum Profit	Net option premium received, $75

Explanation and Application

Verticals are the most basic option spread. You're hedging one option with another: when one makes money, the other loses money. The idea is that in exchange for relatively low risk, you're giving up the possibility of stratospheric gains. But don't scoff. Verticals (either a bull vertical or bear vertical) are popular with professionals because of their limited risk nature and their profit potential that, though limited, can still amount to many times the risk taken. In many stocks, option volatility and margin requirements are so high as to prohibit either buying or selling options outright, whereas verticals typically don't have such high cost or prohibitive margin requirements. Verticals can offer investors an efficient way of creating long or short exposure in a stock.

Before we proceed, understand that a bull vertical is always long a lower strike option and short a higher strike option, and can be either a long call vertical or a short put vertical. Conversely, a bear vertical is always short a lower strike option and long a higher strike option, and can be either a long put vertical or a short call vertical.

It's not enough to know a bull vertical spread is used when you are bullish and a bear vertical spread when you are bearish. Should you be considering a vertical that's in-the-money (ITM), at-the-money (ATM), or out-of-the money (OTM)? With respect to the stock's current price, a vertical might have one option ITM and one OTM making it an ATM vertical. Therefore, an ITM vertical is one where both options are currently ITM, and an OTM vertical is one where both options are currently OTM. Do you want the passage of time to help you, or are you willing to let it hurt you? Do you think implied volatility will rise, fall, or stay the same during your time frame? Verticals can be created to meet these requirements.

Calls, Puts & Covered Writes

Essentials

Long Call
Long 1 XYZ Sep 50 call @ $2.00
Total Cost	Option premium paid, $200
Maximum Loss	Option premium paid, $200
Maximum Profit	Unlimited
Short Call
Short 1 XYZ Sep 50 call @ $2.00
Total Credit Received	Option premium received, $200
Maximum Loss	Unlimited
Maximum Profit	Option premium received, $200
Long Put
Long 1 XYZ Sep 40 put @ $1.00
Total Cost	Option premium paid, $100
Maximum Loss	Option premium paid, $100
Maximum Profit	Unlimited
Short Put
Short 1 XYZ Sep 40 put @ $1.00
Total Credit Received	Option premium received, $100
Maximum Loss	Unlimited
Maximum Profit	Option Premium Received, $100

Explanation and Application

Before you can trade the more complicated option positions, it would be wise to understand their building blocks: calls and puts. Critics of option trading always point out how risky, speculative, and unnecessary options are. But what they either don't understand or point out is that options are designed to be a tool for transferring risk from one trader to another. It is imperative to understand that when buying calls or puts, the potential loss is limited to the amount paid for the calls or puts. When selling calls or puts, the potential loss is unlimited (short puts really have risk limited to their strike price, but are considered unlimited for all intents and purposes). Therefore, when you buy an option, you are limiting your risk by transferring it to whomever sold the option. When you sell an option short, you are accepting the risk from whoever bought the option. Options can offer a great deal of leverage, meaning that you can have the risk/reward exposure of a large position in stock for a relatively small amount of money.

It's important to understand that there are trade-offs in options. There are good points and bad points about every option strategy. You must isolate your speculation, i.e. precisely what do you think is going to happen to a stock and when is it going to happen? You must balance potential risk versus potential reward. Always keep in mind that in option trading, you never get anything for free.

A Gold Update

Gold has been on a wild ride the past month or so after collapsing below 1700 just days after I posted about the "The Gold Triangle" breaking down. The gold market built an impressive and impulsive rally up over 120 points since bottoming a few weeks back at 1525. Today we touched a high of 1648 before pulling back and closing a bit off the high. This area is important because the swing high from Dec 21 was 1643 and if gold can close above this level it will be on its way to attracting buyers up to 1680 next.

It is a bit overextended short term and could use a 1-2 day pullback and if this occurs it should hold the 1613 level of support which is now a 1 year VPOC where alot of business has been done as you can see the daily chart above. On the profile there is a little volume pocket up to about 1700 so buyers could drag it up to there easily.

The downtrend line from the Sept and Nov highs comes into play a little higher near the 1690-1700 zone and will definitely give gold a tough time if it gets there. Also the LRC channel has resistance in that area currently.

On the bullish side the TTM trend has been back to a buy signal for 6 days now and the DMI is crossing back into green buy mode. We are entering a more quiet time of year for metals as they historically consolidate into early Spring so this could result in a base being built between 1600 and 1700 in the coming weeks. All in all, it seems to me like downside in gold is limited and dips are buys as long as it holds above the 1613 zone of support.

The Gold Triangle

Feb Gold futures $GC_F have been consolidating into a big triangle the last few months since topping in early September. The price action has been less than bullish most of the last month forming a sloppy slanted head and shoulders pattern which should point to a move back down to 155 at the least. Gold tried to get back above the 1800 level--which was just about the 61.8% retracement of the entire decline from early Sept--but failed to attract buyers at that level and quickly auctioned lower.

Today the break of the big triangle is confirming that the gold market is going lower in the short term. The big signal to me was last week when gold ran up to 1760 and stopped on a dime and reversed back down to 1710 that same day to put in a bearish outside reversal candle trapping bulls above 1750-1760. That usually indicates much more than a 1 day move coming.

Looking at the volume profile chart you can see the big supply overhead that put a ceiling in gold and there is some decent support down to 1625 but below that there is a volume pocket down to about 1540, which coincidentally is also where the 61.8% retracement of the entire bull run of 2011 from 1309 low in January to 1923 high in September.

• Today, the TTM trend turned back to confirmed sell signal with two red bars on the daily.
• The DMI also is in bear trend mode with the histograms still red, saying the sellers are in control.
• I dont think gold crashes into the next month but short term the risk is to the downside no doubt and shorting rallies into resistance is a profitable strategy.
• The 200 EMA on GLD is near 157 and that looks to be tested if today's high (1718) is not regained.
• I would look to buy January puts or put spreads on any bounce back to the 1680s on the gold futures or about the 163's on GLD.
• Also for daytrading the gold futures are a great contract to trade for intraday and should provide plenty opportunity going into 2012 as well.
• Long term I think gold is still alright on the monthly chart and should hold 150 on $GLD during this correction before it starts a new uptrend but not right now, there are just too many trapped bulls who bought the parabolic climb in late summertime and are now providing the fuel on downside as they sell.