Best of the Week
Most Popular
1.UK House Prices BrExit Crash NOT Likely Despite London Property Market Weakness - Nadeem_Walayat
2.BrExit Morning - New Dawn for Britain, Independence Day! - Nadeem_Walayat
3.LEAVE Wins EU Referendum - Sterling and FTSE Hit Hard, Pollsters, Bookies and Markets All WRONG! - Nadeem_Walayat
4.BrExit Implications for UK Stock Market, Sterling GBP, House Prices and UK Politics... - Nadeem_Walayat
5.Trading BrExit - Stocks, Bonds, Sterling, Opinion Polls, Bookmaker Odds and My Forecast - Nadeem_Walayat
6.FTSE and Sterling Brexit Trading, Deconstruction of the EU Referendum Result - Nadeem_Walayat
7.UK Interest Rate Cut to 0.25% Imminent and More QE Money Printing - Nadeem_Walayat
8.Trading BrExit - British Pound Plunges, FTSE Stock Futures Slump on LEAVE Shock Referendum Win - Nadeem_Walayat
9.The Stock Market is Reading it Wrong! - Chris_Vermeulen
10.Breakouts Galore in Gold and Silver - Jordan_Roy_Byrne
Free Silver
Last 7 days
The State Of The Economy - 28th July 16
Elliott Wave Crash Course - 3 Ways the Elliott Wave Principle Enhances Your Trading - 28th July 16
Japan's "Helicopter Money" Play: Road to Hyperinflation or Cure Debt Deflation? - 27th July 16
Monetary Zika - The Insidious Nature of Credit Expansion - 27th July 16
Gold and Pork Bellies - 27th July 16
Silver Is Insurance Against The Worst Part Of This Depression - 27th July 16
Don’t Buy The SPX Hope Stock Market Rally! - 27th July 16
Bitcoin $650 Still in Play - 26th July 16
Deutche Bank Stock Price Crash - The EU Has Problems Far Beyond the Brexit - 26th July 16
The Forex Markets Are Getting Exciting! - 26th July 16
Underpriced Silver Is the “Rip Van Winkle” Metal - 25th July 16
Declines in Multiple Market Indexes - 25th July 16
Retailers Are Doomed as Most Americans Are Too Poor to Shop - 25th July 16
Here’s One Currency That Could Go to Zero - 25th July 16
Stock Market Top is Expanding - 25th July 16
Silver Manipulation – Because They Needed the Eggs - 25th July 16
Silver Market COT Stuns: What's Going On Here? - 24th July 16
Gold Demand Remains Stable During Sector Weakness - 24th July 16
Sernova, Diabetes and Haemophilia - 24th July 16
Russia: Tensions, Turmoil, and Western Hubris - 24th July 16
Soybean Commodity Price to Soar Again - 23rd July 16
SPX Stock Market Uptrend Continues - 23rd July 16
Gold And Silver – Debt Addiction Will Carry Precious Metals Higher, Guaranteed - 23rd July 16
Pokemon Go - How to Play, First Use, Balls, Stops, Catching Pokemon's... Great Excercise! - 23rd July 16
7 Signs That the Gold Market Remains Resilient - 23rd July 16
Basic Income in The Time of Crisis - 23rd July 16
Silver Bull Faces Correction - 22nd July 16
The Serious Warning No One’s Talking About - 22nd July 16
Stock Market Insight from Greed, Volatility, and Put/Call Ratio - 22nd July 16
What Will Happen To the Stock Market When Interest Rates Rise? - 22nd July 16
How to Escape the World’s Biggest Ponzi Scheme - 22nd July 16
Addicted to Debt - We Can’t Borrow from the Future Anymore - 21st July 16
Not Everything Is Bullish for Gold - 21st July 16
Don’t Get Sucked Back Into the Stock Market - The Big Picture Hasn’t Changed - 21st July 16
Silver – Caught Inside - 21st July 16
Forex: "The Markets Are Getting Exciting!" - 20th July 16
China Economic Troubles - Is Kyle Bass Finally Getting His Revenge? - 20th July 16
Why Lithium Will See Another Price Spike This Fall - 20th July 16

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

The Power of the Wave Principle

Using a Put Butterfly to Options Trade Cummins Inc.

Companies / Options & Warrants Dec 22, 2012 - 03:17 AM GMT

By: J_W_Jones

Companies Entomologists tell us that a group of butterflies can, at the choice of the writer, be termed a lek, a rabble, or a swarm. I was first struck today by the bearish Fibonacci based pattern initially described by Larry Pesavento termed a bearish butterfly which had completed in heavy engine manufacturer Cummins Incorporated (symbol CMI).  


As improbable as it might be, I was pleased to find that a high probability option structure that could be used to trade it, the put butterfly. I thought it would be interesting to examine for educational value this rabble.

First, let’s look at the chart pattern. The price pattern termed a butterfly is a high probability reversal pattern that can occur in both bullish and bearish configurations. It is a variant of a two step pattern and also a variant of a more commonly known Fibonacci pattern, the Gartley.

The essential elements of the pattern are an initial impulsive thrust (classically termed the X:A leg), a reversal of 0.618 to 1.00 of the initial thrust (the A:B leg), a second thrust in the direction of the initial leg (the B:C leg), and the final reversal thrust opposite in direction from the initial X:A leg extending from 1.272 to 1.618 of the initial leg. 

Verbal descriptions are confusing, but consider the characteristic visual pattern which is easily recognized once the trader is familiar with the pattern.

The pattern completed last Friday as indicated on the graph, and today’s bearish candle constitutes a trigger for the trade. These patterns have approximately a 67% probability of success.

The option position I chose to trade this pattern is that of a classic put butterfly. For those not familiar with this structure it is a three legged structure that is composed of long positions for the wings and a short position for the body. 

The classic butterfly is always constructed in the ratio 2/+1 and the long positions are equi-distant from the short position comprising the body. The position is a debit position meaning that money is deducted from the buying power of the account.

An option butterfly can be constructed using either puts or calls. It is important to understand that the maximum profitability of these trade structures occurs when price is at the strike of the body at expiration.  Therefore, if an individual butterfly is constructed to express a directional bias, it can be constructed using either puts or calls since the strike price of the body determines maximum profitability.

As an aside, variations of a classic butterfly do exist. Two commonly encountered variants are an iron butterfly and a broken wing butterfly.  The iron butterfly is a credit trade and is constructed using both puts and calls. 

The broken wing butterfly is built by buying the long options at different distances from the central body. We will discuss these less common positions as different trading opportunities are presented to us.

To return to our current situation in CMI, I chose a put butterfly using the 90/100/110 strike prices in the January series. I chose January because December expiration is only a few days away, and butterflies work best when given a bit of duration. 

Had weekly options been available for this underlying, I likely would have chosen to use them in order to tailor the time frame a bit shorter to allow a faster response to changes in P&L.

The P&L graph of this put butterfly is presented below.

Pay particular attention to the intermediate time curves indicated by the two broken lines in relation to the expiration curve indicated by the solid blue line. The broken lines represent the P&L today (the lower broken line) and halfway to expiration (the higher broken line). Note that the butterfly only reaches its maximum profitability at expiration.

Another characteristic is the difference in slope of the intermediate and expiration lines. While the intermediate time frames react gently to changes in price, the pace of reaction to price change increases dramatically as expiration approaches.

It is for this reason that many option traders routinely close their butterfly positions ahead of expiration. Most experienced butterfly traders do not allow their positions to go to expiration because of the position risk with adverse price moves.

We welcome you to try our service to learn about more high probability trade set ups and option positions to extract potential profits while defining risk precisely.

If you are looking for a simple one trade per week trading style then be sure to join www.OptionsTradingSignals.com today with our 14 Day Trial.

 J.W. Jones is an independent options trader using multiple forms of analysis to guide his option trading strategies. Jones has an extensive background in portfolio analysis and analytics as well as risk analysis. J.W. strives to reach traders that are missing opportunities trading options and commits to writing content which is not only educational, but entertaining as well. Regular readers will develop the knowledge and skills to trade options competently over time. Jones focuses on writing spreads in situations where risk is clearly defined and high potential returns can be realized. 

This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.  


© 2005-2016 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife