Collar iron butterfly?

Discussion in 'Options' started by optionsgirl, Mar 21, 2009.

  1. I don't know what this strategy is called, but I think this is probably similar to a short iron butterfly. I wanted to find a way to hedge a collar and I ended up with something like a short iron butterfly. Here is my thought process:

    Standard collar:
    Long stock + ATM long put + higher strike short call.

    Now I take a reverse position:
    Short stock + ATM long call + lower strike short put

    So my total positions:
    Long stock (100 shares)
    Short stock (100 shares)
    1 ATM long put
    1 ATM long call
    1 higher strike short call
    1 lower strike short put
    :
    :
    Since it is cheaper to use a short synthetic, I would use a short ATM call and long ATM put. It would look like this:
    Long stock
    2 ATM long puts
    1 ATM long call
    1 ATM short call
    1 higher strike short call
    1 lower strike short put

    However, the ATM long and short call cancels each other out so the final position should be:
    Long stock
    2 ATM long puts
    1 higher strike short call
    1 lower strike short put

    What I ended up with is what Lawrence McMillan calls a reverse hedge except that he didn’t add the short options in the mix. Since he says the reverse hedge is equivalent to a straddle, this would be equivalent to a short iron butterfly. I don’t understand why he would deem the regular reverse hedge inferior to buying a regular straddle since they are the same thing, except that I get to collect dividends. If that is the case, then would a regular short iron butterfly be superior to this collar short iron butterfly? What am I missing? If I pick a stock that is about to go ex-dividend soon, I should increase my likelihood of some kind of small profit and lower my risk. I suppose I do have to put up a lot more capital for the long stock and 2 long puts than buying a long straddle...
     
  2. I don't know what you mean by hedging a collar. The collar is the hedge. Also, a collar is equivalent to a vertical spread.

    If a collar is equivalent to a vertical and you combine a bearish and a bullish vertical anchored at the same same strike, you end up with a butterfly. All of the above combinations are the same position just in various equivalent forms.

    No, what you ended up with was a butterfly. He's talking about something else.

    Yes, a reverse hedge is equivalent to a straddle. No, a short iron butterfly is not equivalent to a straddle.

    First, dividends are priced into the options so they're not relevant. A reverse hedge is inferior to a straddle because there are more legs. More legs means more commissions and more slippage.

    Clear as mud? :)
     
  3. Well, if the stock goes down and stayed down, I would lose money on the collar. I was just finding a way to see if I could counteract that.

    When I said “this” is equivalent to a short iron butterfly, I meant the final position that I ended up with. Sorry, for the unclear language. But yeah, like you said earlier, it does just appear to be a regular iron butterfly... I guess it is difficult to come up with a new strategy. Every time I come up with some hare brained idea, it ends up to be some modified form of existing strategies --kind of like reinventing the wheel.

    More legs? Well, McMillan said that long stock + 2 ATM long puts is a reverse hedge. I don’t understand how this would have more legs than a straddle...

    I haven’t investigated using the (long stock + 2 ATM long put) strategy to capture dividends, but I did look into using a synthetic short to capture dividends. I was looking at Alcoa a while ago, and right when it went ex-dividend, I checked the option prices of the first two expiration months for a synthetic short position. It appears to me that the synthetic short did offset the loss of the Alcoa stock price. I’ve checked this synthetic short strategy a few times before with other stocks and it appears to be a working form of dividend arbitrage. In some cases, the synthetic short more than offset the loss of the stock. However, if I bought longer term options, the synthetic short didn’t cover the stock losses... Also, someone needs enough capital to offset the loss from commission (and probably slippage) to make this strategy worth while. Perhaps I am missing something again and these ideas (both the synthetic short and reverse hedge) are dead in the water for capturing dividends...

    I appreciate the time you took to reply. Thank you kindly. :)
     
  4. Everyone loses money on stocks that go down and stay down. The purpose of a collar is to put a floor under you. You can modify it by overwriting the calls or buying more puts but either way you give up some upside in return for less downside. The best way to avoid loss is to only buy stocks that go up or get out of the way when they're heading down.

    FWIW, most people are spooked by overwriting, especially noobs who are conditioned to believe that naked means unlimited risk. I think that at times it's a good strategy for even a covered call writer, particularly when you're writing OTM CC's (perhaps -6 calls per 500 shares). But no one should attempt this at home without the supervision of someone who knows how to determine a position's risk graph :)


    There's nothing wrong with exploring hare's brains (g). It's the deer in the lights routine that needs to be avoided.

    You're right in that there are the same number of legs but you have 3 components and that means an extra B/A spread to pay in and out and possibly more commissions if you pay by the contract. Of more importance is that few (if any) brokers offer pre-set equivalent orders whereas as everyone offers a straddle order where you can split the bid, looking for a better fill. With long stock and 2 long puts you have to either accept the current prices or leg out. Although it's not for most, I usually prefer to leg out but I don't want to give up the choice of the pre-set order in case I need to enter or exit quickly and expediently.


    You're not going to find an edge on the retail side. With their lower cost of carry and margin rate, floor traders will grab all mispricings. You might get lucky and grab an occasional bad price entry from someone else but they'll be few and far between.


    You're quite welcome. It's part of my probation agreement :)