Here is an ideal example of the debit structure being paid by the credit structure. The sole purpose of this article is not necessarily to teach what a Butterfly or short vertical is, but to elaborate the advantage of utilizing these structures to offset each other to the virtually no out-of-pocket cost. There is going to be the explanation of trade entry and trade exit.
PART I: ENTRY
On 11/24/2021 the Tesla stock (TSLA) was trading at 1115 as shown on the chart below. The pattern known as a Bull Flag was indicating that there was a possibility of TSLA lifting to at least 1185.
From all the possible option choices that could be selected, the cycle that was expiring in ten days was chosen, namely Dec 3rd. Then the Call Butterfly was placed for the 1.95 debit, followed by a credit structure which paid for it. As the quick explanation Call Butterfly was composed of two call verticals. The Bear -1185/+1210 Call and Bull +1160/-1185 Call shared the same strike price of 1185 which was our upside target. The Figure 1 shows the entry ticket of Call Butterfly with all the relevant details. The value of Bull Call was 8.82 (34.43–25.61) and value of Bear Call 6.87 (25.61–18.74). When subtracted (8.82–6.87) the debit of 1.95 was created and charged by the broker for that particular structure.
Revisiting our thesis, “let the credit structure pay for our debit structure” brings us to the second trade. In this case, a quick glance at the chart above is needed to observe that the top of TSLA gap was at 950. The green line is used to make that assertion of 950 more obvious. If the TSLA stays above that gap, it is bullish for the stock. Hence the Bull -950/+930 Put was selected. This credit structure had the mid-price of 2.11 credit. Although both trades were entered at the same time, the actual fill for the Bull Put took place at 7:23 PST as the TSLA was fluctuating in the area between 1110 to 1115. Often patience pays off when entering the credit spreads such as Bull Put or Bear Call. Getting an instant fill at the limit price would mean that more premium could have been obtained had we waited a bit longer. In this case we waited almost twenty minutes, which has its pros and cons.
After receiving the credit of 2.11, our debit of 1.95 was covered, yet the more important question to ask is: what the Margin outlay for this whole trade is. The answer is at nearly 2,000 which is the width of Bull Put spread. As shown in Figure 2 the 950 put was sold and the 930 was bough. For those 20 points we have received the credit of 2.11 which is about 10% rate of return on investment, if the TSLA closes above 950 on Friday December 3rd expiry.
The goal of overall trade for both structures was to see the TSLA lift toward 1185 but not close above it. In that scenario the call Butterfly would expand, and it could be closed for higher premium than 1.95 while the Bull Put spread would go out worthless. Next let us examine, whether that initial prediction materialized.
PART 2: EXIT
A few days after the TSLA entry and the entire Technology sector was under a selling pressure. Although there was a rally on 12/1 as high as 1172 it was followed by a rapid drop to as low as 1127. During the drop, the choice was made to unwind the top of part of the Butterfly, namely the Bull Call part, leaving the Bear Call alone. The Figure 3 shows that the credit of 5.70 was received. Hence, from the original value of Bull Call 8.82 most of the money was salvaged; to be exact $312 was lost (8.82–5.70).
As a result of closing the Bull Call, the Call Butterfly was no longer in the existence, for a new trade that did not exist before was created. It was an Iron Condor made of the Bull Put & the Bear -1185/+1210 Call that was 25 points wide. The width of Bear Call turned out to be greater than the width of Bull -950/+930 Put which was only 20. Hence the margin requirement by the broker has altered from 2,000 to 2,500 due to this adjustment. The brokers always take the higher margin, in our case the Bear Call’s side.
On the technical side, the possibility of TSLA revisiting 950 was very realistic. Therefore, the fact that the Bear Call spread would expire worthless would not help our Bull Put if it got rapidly pierced and TSLA closed anywhere within the spread. The decision was made on 12/1 to wait for the opening of the next day and observe if the TSLA would take out its 12/1 low and travel lower. As the Figure 4 shows, by 7:44 PST it was clear that not only TSLA but also the entire Tech sector was going lower. The order to close the Bull Put was entered, at the time when the TSLA was at 1058 or still a hundred points away from the sold 950 strike. Once it was filled for 0.76 the obligation was lifted. Even though Bull Put spread was supposed to expire worthless, and the overall trade did not work out as planned, some profit was made. Specifically, the received credit of 2.11 was covered for 0.74 earning $135.
In conclusion, the TSLA was at 1115 when the Call Butterfly (a combination of a Bull Call & Bear Call with the same sold strike price at 1185) was entered. Within the minutes of getting filled, the debit structure was financed by the Bull Put. Observe that all these trades had the strikes that are out-of-the-money.
After the TSLA lifted to as high as 1172 it started to fail. The follow-up action was needed. First the unwinding the Call Butterfly was done, and the loss was taken on the Bull Call component, leaving the Bear Call alone. Then the Bull Put was exited, completely switching the Bullish bias to Bearish bias. For the simplicity’s sake, the Table below summarizes all the details of this trade:
This bullish trade has gone south and there was a possibility that the losses might accelerate. Yet what saved the trade was that all the traded units were out-of-the-money. However, most of the profit did not come from the Bull Put but from the Bear Call spread which was initially a part of the Call Butterfly. The TSLA settled on 1003.42 and Bear Call expired worthless. At the end the total of 480 was earned.
It is always a good feeling of being wrong, but still profitable. Yet it is all about the follow-up action and preplanning the trade beforehand.
If you have any questions, I would be happy to answer them on the tradewithufos.com website. You can go to www.tradewithufos.com/josip and scroll to the bottom where you will find a Q&A box.