The Butterfly Lotto Ticket

Good Morning!

This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

Quote of the day:

"Fly, fly, fly away, butterfly"

Believe it or not, but Jenny was actually a budding options trader. This tear-jerking scene of her and Forrest praying about escaping her father just scratches the surface.

She was really praying that the market would settle at the center of her long butterfly on the day it expires! Don't believe me, look at the hidden symbolism in her arms...

Yep, there it is: the long butterfly expiration curve!

In the context of last week's pinning the 3835 strike, let's see how a butterfly can act like a lotto ticket.

BANG for Your Buck:

• SPX ref = 3839.50

• BANG (daily) = 52 handles of movement ~1.3%

• BANG (weekly) = 115 handles of movement ~3.0%

In the coming week, this section will be beefed up with even more relevant and actionable data such as: weekly bang review, overnight expectations, gap probability analysis, and more! Believe it or not, the market just kinda tells you all this stuff, if you know where to look...

Today's Learnding Moment

How is a Butterfly like a lotto ticket?

Similar in Setup

To win the lotto, you need to pick the correct numbers AND buy the ticket for that day!

To get handsomely paid for your butterfly, you need to pick where the underlying will close for a specific date.

You're basically just picking numbers!

Similar in Timing

The lotto ticket doesn't payout early. Some jag on the evening news needs to coax those balls out of some crazy contraption first!

With the butterfly, there is little value appreciation until the options are near expiration and very close to being a massive win i.e. if you think you are going to sell this early when it seems to be going in your favor, you picked the wrong strategy.

It would be like selling your lotto ticket as the numbers are coming out. Say the first 3 numbers come out, you have 'em on your ticket, and only then someone might say "I'll buy that ticket off you for $50". Probably not a smart move to sell your "winning-so-far" ticket considering if it were to actually hit, you wouldn't be able to live with yourself being the world's biggest pu$$y!

On the other hand, these tickets really don't depreciate before those numbers are pulled, so selling the ticket for a small loss or scratch is possible.

Similar in Cost vs Payout

Both are cheap with limited loss.

A lotto ticket can be a buck or two, and can pay out MILLIONS. 

Let's run the real-world example, with the JPM quarterly collar roll as the motivation for my price and time prediction. Let's say I saw the strikes they traded and think "that upside call (Dec 30th 3835 Call) seems like a reasonable target for the year end print." 

So, I buy a 25 handle even fly centered at 3835 for $1.80 (x100 = $180 outlay). Pretty cheap, right?

• Long Dec 30th 3810 Call 1x

• Short Dec 30th 3835 Call 2x

• Long Dec 30th 3860 Call 1x

On Dec 30th, the market settles at 3839.50. My fly pays out $1870 [(3835 - 3810) + (3835 - 3839.50) - 1.80) x 100]

Not a bad 10x return for being completely correct.

Now what if I had bought the 3840 fly only 5 handles wide for $0.25...the payout would've been an 18x winner.

As with lotto tickets, these are really tough bets to win! 

Make Me a Better Trader

The goal of this section is to build your intuition about trading, option structures, position management, market flow analysis, etc.

Today, we are going to explore the Butterfly (fly) option structure.

I could easily put up an option expiration graph (see Jenny's arms for reference) and start teaching from that. But the "memorization" of typical strategy names and expiration curves won't help you in the long run. To have confidence with options, you need to be able to design long and short option positions to get your desired outcome.

What is the desired outcome for a lotto ticket?

See above: pick the right numbers, for the right date, don't pay a lot, but have the ability to win big.

Let's think about a number line. If I know where the price ends up at a specific date and time (yellow), I know what all calls and puts should be worth as well.

Both call and put options at the settle price (yellow) are worth ZERO on expiration.

Since calls get cheaper as their strike price increases, and puts get cheaper as their strike price decreases: the most expensive stuff that I can sell that will expire worthless (i.e. make the most profit) are the options at my predicted settlement price.

That's a start, except selling a call has unlimited loss potential and isn't a cheap fixed cost.

Okay, so let's limit loss. Buy a call option higher to limit max loss. 

Cool, so we are short a call where we think the market will settle, and long a higher call to limit our loss in case we are wrong. 

But we also want to get paid out handsomely when we are absolutely correct!

Alright, we need to buy a cheap call that we know will end In-The-Money (ITM) and sell an expensive call that we know will be worthless (this one rings a bell!)

Buy a lower strike call (the closer to my predicted closing price, the cheaper it will be) and sell the call at the strike where we think the market will settle.

Well look what we have here, long 1 lower, short 2 at my prediction level, and long 1 higher.

 It satisfies my "lotto ticket" requirements, and it just so happens to be a well-known option spread called a butterfly.

How do you think we'd modify the location of our option positions if:

• We wanted to make more money when we're right

• You don't know the exact settle price, but rather a range

• You know where it will go in 20 days from now, and then to an unknown different price in 30 days

We'll get into all these types of questions and more! Oh, and think about what happens when a position actually requires management?!

As always, pursue the process NOT the profits! See you tomorrow!