Best of the Week
Most Popular
1.UK General Election 2015 - Forecasting Seats for SNP, LIb-Dems, UKIP and Others - Nadeem_Walayat
2.UK General Election 2015 Seats Forecast - Who Will Win? - - Nadeem_Walayat
3.Gold Price Downtrend Looks Set to Continue - Clive_Maund
4.Commodity Prices Set To Plunge Below 2008 Lows - Austin_Galt
5.New Greece Drachma Revealed Amid Bank Runs - Greeks Buy Gold Sovereigns - GoldCore
6.Gold and Silver Stocks or General Stock Market Indices? - Rambus_Chartology
7.“Forgive Us Our Debts” – Only Way To Prevent Economic Meltdown - GoldCore
8.UK House Prices Trend 2015 and the May General Election - Nadeem_Walayat
9.12 Reasons Why Barry Ritholtz and Many UK Experts Are Mistaken On Gold - GoldCore
10.Recession is On The Way; Beat The Stock Market Crowd, Panic Now! - Mike_Shedlock
Last 5 days
Gold Price and Mining Stocks Decline Together - 3rd Mar 15
Financial Slaughter - The Silence of the Lambs - 3rd Mar 15
Bondholders “Bailed In” In Austria – New Banking Crisis? - 3rd Mar 15
How to Profit from the Coming Oil Price Crunch - 3rd Mar 15
Is Japan Zimbabwe? Could Japan go Hyperinflation? - 3rd Mar 15
Bill Gross Says Fed May Raise Rates 25 Basis Points in June - 3rd Mar 15
The Secret Behind My Hedge Fund Trade on U.S. Housing Market - 3rd Mar 15
BLS CPI Lie - How's That Dsflation Working Out for You? - 3rd Mar 15
Tesla Bonfire of the Money Printers’ Vanities - 3rd Mar 15
Gold Demand in UK, Europe and U.S. – Reuters Interview GoldCore - 2nd Mar 15
Watch the Skies... for Investor Profits - 2nd Mar 15
How Investors Can Identify the Best Small-Cap Stocks - 2nd Mar 15
Gold and Silver - What If the Precious Metal Stocks Bulls are Back - 2nd Mar 15
Students Getting a PhD in Subprime Debt - U.S. Debt Breaking Bad Part 3 - 2nd Mar 15
The Stock Market is in The Process of Major Top! - 2nd Mar 15
Stock Market Weakening Trend - 2nd Mar 15
Gold Price Glimmer of Hope - 1st Mar 15
Stock Markets Are Riding High on Thin Air - 1st Mar 15
Varoufakis vs. the Troika - Showdown in Athens - 1st Mar 15
Subprime Rising - U.S. Debt Breaking Bad Part 2 - 1st Mar 15
Gold CoT Improving, But ... - 1st Mar 15
UK General Election 2015 Seats Forecast - Who Will Win? - 28th Feb 15
UK General Election 2015 - Forecasting Seats for SNP, LIb-Dems, UKIP and Others - 28th Feb 15
Stocks Bull Market Continues - 28th Feb 15
U.S. Debt Breaking Bad - 28th Feb 15
NATO Frankenstein - When Centralization Scales Beyond Our Control - 28th Feb 15
Gold And Silver Insanity Prevails; Precious Metals Without Direction - 28th Feb 15
Fed Raising U.S. Interest Rates - Shovelin’ Schmitt Against the Tide - 28th Feb 15
Don't Let This Stock Market Myth Cost You Your Gains - 28th Feb 15
Recession is On The Way; Beat The Stock Market Crowd, Panic Now! - 28th Feb 15
Stock Market Indexes Creeping Towards the Edge - 28th Feb 15
GGD Going for Mexican Gold - 27th Feb 15
Foreign Real Estate Is the New Swiss Bank Account - 27th Feb 15
10 Reasons Washington Has War Fever - 27th Feb 15
Gold and the Euro Tragedy, Iraq 3.0, Ukraine Conflict Three Ring Circus - 27th Feb 15
Deepak Chopra - New Age Genius or Bullshit Expert? - Video - 27th Feb 15 - Videos
New Greece Drachma Revealed Amid Bank Runs - Greeks Buy Gold Sovereigns - 27th Feb 15
Will Month Long Stocks Rally Continue? - 27th Feb 15
The Only Public Hedge Fund You Should Own - 27th Feb 15
UK House Prices Trend 2015 and the May General Election - 27th Feb 15
Why America is Ungovernable - The Republicans’ Civil War - 27th Feb 15
Gold vs Gold Stocks: Bullish Anomaly Developing? - 27th Feb 15
I Heart Capitalism, Nasdaq Stocks, Then And Now - 27th Feb 15
The Fed’s History of Assassination - 27th Feb 15 i
Gold Bull Market Forecast - Money Will Rotate Into These Dead Investments - 27th Feb 15
"Audit the Fed"? We've Already Done That (Well, Kind of) - 26th Feb 15
Forget Peak Oil; Worry About Peak Demand - 26th Feb 15
Currency Wars, Again - 26th Feb 15
The Fed Waited Too Long: Here Comes Inflation - 26th Feb 15
Investing Inertia Won’t Keep Your Cash Safe - 26th Feb 15
The Net Neutrality Scam - 26th Feb 15
Will Conservatives Out of Control Immigration Crisis Boost UKIP Election 2015 Prospects? - 26th Feb 15
EU Warns Ireland and Euro Zone of Debt Dangers - 26th Feb 15
Commodity Prices Set To Plunge Below 2008 Lows - 26th Feb 15
Ukraine Hyperinflation as Currency Plunges 44% in One Week! - 26th Feb 15
The State of the Global Markets 2015 - 53 Page Report - 26th Feb 15
NASDAQ New 15 Year High - Stock Market Death By Overdose - 25th Feb 15
12 Reasons Why Barry Ritholtz and Many UK Experts Are Mistaken On Gold - 25th Feb 15
Sugar Commodity Price To Sweeten Up - 25th Feb 15
Investor Profits from China 2,000-Year Unstoppable Trends - 25th Feb 15
How to Borrow Cheaply from a Government-Owned Bank - 25th Feb 15
Debt Be Not Proud - 25th Feb 15
Liberal Democrat Election Blood Bath - Could Nick Clegg Lose Sheffield Hallam? - 25th Feb 15

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

The State of the Global Markets 2015

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.  


© 2005-2015 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

Free Report - Financial Markets 2014