Question/thoughts for long spread/iron butterfly traders. My problem is trying to accurately calculate the potential gain in my strategies, factoring in implied volatility. The problem: Every website on earth tells you the maximum profit from a debit spread is the difference in strikes minus the premium paid. This is correct; it is the "maximum/theoretical profit" Real life: This never, ever happens. The real life gain is the difference in strike prices minus the difference in time value minus the paid premium. Example: XYZ = $100 Predicted move of +$5, so we open a 5-point call spread. Let's say we paid $400 BUY $100 CALL - 8.0 paid Sell $105 CALL - 4.0 received Stock now moves to $105 - implied volatility dropped due to post-earnings announcement $100 CALL = +5.50 ($5 in-the-money for intrinsic value, small time value of 0.5) $105 CALL = -2.0 ($0 in-the-money, 2.0 time value ) _________________________ =3.50 Notice the move happened and we lost $50? As you can see, an at-the-money strike has a very high amount of time value, which is affecting how much we can sell the spread for. Thus, you can see you will have to subtract the difference in time values from the actual spread to calculate profit. You don't just want your spread; you want even your short call to be WAAYYYY in the money, to shorten the difference in time values. Does anybody look at these when running calculations? I've had trades recently where I predicted an 8% movement. So, I pick a safe trade....a 4% movement spread. The stock moves 9%, WAYYY above my spread......and I lost money. The volatility was so high in my short contracts, that over 2X my predicted move happened, and it still wasn't profitable. Perhaps there's a calculations to figure out how far in-the-money the short call has to be in order for the trade to still be profitable?
Theoretical value is all you need - so what if you are off by a few dimes (usually minus a few dimes) when you close the position? Just like when you buy that gallon of paint from Home Depot - do you think it will cover the square feet the label claims it will? Of course it doesn't. It is what it is.
Well, the reason why I worry about it is because it can turn into an unprofitable trade. I believe that's good cause. You could have have a spread to that has max profit of 10%, and a very small difference can turn the trade unprofitable. The question: Does anybody have any actual recommendations to calculate risk/rewards using this method?
calculating where vols will be after a spot move is one of the more important aspects of volatility trading.
Re: "You could have have a spread to that has max profit of 10%, and a very small difference can turn the trade unprofitable" Could you be more specific? Is that a credit spread with a risk:reward of 10:1? If so it's obviously deep OTM and should remain OTM until expiration - if not then no amount of IV calculations will save it.
Sure, in a real life example Ticker: BIIB - $265.8 price @ time of trade Strategy: Long iron butterfly SHORT $252.5 PUT LONG $265 PUT LONG $265 CALL SHORT $277.5 CALL ------------------------- Price was net debit of 10.3, anticipating a move of at least 12.5. In actuality, this was roughly a 4.4% move that I needed, which was half of what I really anticipated (8.8%) POST EARNINGS: Stock now at $285 Stock is now up 7.2%, and 7.5 points above my call spread Even the midpoint of my butterfly was only 7-8 points, well below what I paid. Luckily, the stock moved to about +9% and I was able to sell my butterfly for 11.4, yielding a 10.6% profit. The real question: is there anyone out there that utilizes this strategy often and has some good calculations for figuring out what the ACTUAL gain will be? I've had situations where the stock moved exactly the amount of my spread, and the time value was so low, I collected my entire spread. I've had other situations where I collected half of my spread, even when the move happened. Since this issue basically lies in the difference in time value (i'm sure heavily affected by IV), i'm looking for guidance at anticipating how the difference between the strikes work, and what % below the actual anticipated move I should place my spread/butterfly.
Are you actually disputing the idea that the value of your spread AT EXPIRY is what the typical P/L diagram shows? What do you mean, "Real life: This never, ever happens." Sure it happens. It happens to the penny with every option combo constructed of same-expiry options. Prior to expiry, it's not nearly so cut-and-dried, but . . .
So you're telling me you had a debit spread where the underlying moved *up* past both your strikes and you lost money to IV of the short side vs your long side? What's was the actual real world example of this where it happened to you?
Basically IV will contract on rallies and expand on declines. So use skew measurements and estimates to calculate where prices will be at any given predicted level. Think and learn about stickiness.