With a contentious presidential election being fought, there will be a lot of discussion about health care in 2008. And even though it might be a relatively stable sector, health care stocks are certainly not immune to big market sell-offs and earnings scares. If you’re considering taking a position in a stock in the health care industry, having a relatively low-risk profile is advisable.
Options give you a lot of choices to consider for different types of positions, some with less risk than others. But if you think that a particular stock in the health care industry, like Johnson & Johnson (NYSE: JNJ), might trade in a relatively narrow range, an option spread known as a butterfly might be an interesting choice.
Butterflies are made up of three option “legs,” where you buy a lower strike call, sell two middle strike calls, and buy a higher strike call. For example, in a stock like JNJ (about $60 at the time of this writing), you could buy a 60 strike call, sell two 65 strike calls, and buy a 70 strike call with one month to expiration, for a net debit of about $1.70. How do you arrive at the $1.70 debit? Using current option prices, if you buy one 60 call for $2.50, sell two 65 calls for 45 cents each, and buy one 70 call for 10 cents, you would have a net debit of $1.70, or $170 paid for each butterfly you buy.
The butterfly spread has interesting characteristics. First, depending on where you think the stock might go, a butterfly can be a market-neutral type of trade, where you don’t think the stock will move very much up or down from where it is now, or a slightly directional one, in which you want the stock to go up or down to a specific point. The strike price of the short middle legs is key. If the short middle legs are at a strike price close to where the stock is now, the butterfly is neutral. But if the strike price of the short middle legs is higher—like the short 65 strike legs with JNJ at $60 in our example—the butterfly is slightly bullish. It’s useful to remember that the butterfly wants the stock to be at the short strike at expiration. If the short strike is near, higher, or lower than the current stock price, then the butterfly is neutral or has a bullish bias or bearish bias, respectively.
Second, butterflies have defined risk, meaning the maximum loss on the position is known even before you do the trade. That can make sharp price movements in the stock easier to bear, because you can determine how much risk you are willing to take and buy butterflies accordingly. In our example, the $170 debit of the butterfly is the maximum risk. That happens if JNJ is below $60 or above $70 at the expiration date of the option. With JNJ below $60, the 60, 65, and 70 calls all expire, worthless. If all the options in the butterfly are worthless, then the butterfly is worthless as well. With JNJ above $70, the exact opposite occurs—all the calls are in the money. If JNJ is $71, the 60 call would be worth $11, the short 65 calls would be $6 apiece, and the 70 call would be $1. The butterfly has a $12 value in the long options, but $12 also in the short options. The values offset, and the butterfly is worthless again.
Third, butterflies can have positive time decay, i.e., they make money as time passes. A butterfly will have positive time decay if the stock is close to the strike price of the short middle leg. Given that the passage of time is guaranteed, having it on your side is a benefit. Finally, when volatility is high like it is now, butterflies tend to be less expensive. High volatility pushes down butterfly prices, and low volatility pushes them up. In high-volatility environments, butterflies can be a cheap way to speculate on a health care stock.
So, when do butterflies profit? When the stock is close to the short strike at expiration. In our example, if JNJ is at $65, the short 65 strike calls expire worthless, the long 60 strike call is worth $5, and the long 70 call is worthless. The butterfly is worth the value of the 60 calls. But because you paid for the butterfly, its max profit is the difference between the strikes ($5), minus the initial debit, in this case $330.
You might say that butterflies “spread their wings” in the last week or so before expiration. What happens is that, with more time to expiration, the positive time decay of a butterfly is lower, but it accelerates the closer you get to expiration. That’s why a butterfly position won’t necessarily be profitable—even if the stock is right at the middle strike price—if it’s more than a couple weeks before expiration.
Butterflies may not be for every investor, but in a volatile market, they can be a good strategy if you have a target in mind for the price of the stock
— By Tom Preston
Tom Preston is a founding partner of thinkorswim and the chief
architect of its trading platform. He holds multiple degrees, including
an M.B.A in finance and statistics from the University
of Chicago.
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