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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 +1/-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.
JW
Jones
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