Consistent Profits with Option Butterfly Trades

Tim Bourquin Co-Founder, The Traders Expo and The Futures & Forex Expo

Some people may consider the type of trading that our interviewee for this week does as boring. He puts on the same trades, month in and month out, and manages them the exact same way each time. Yet he makes money on a consistent basis.

In this episode of Trader Talk, we discuss how one trader puts on butterfly option strategies every month and how he manages them close to expiration. We also discuss why this type of option trade suits his personality, and how he came about using the strategy every month to make consistent profits. As well, we talk about the markets this type of option trading strategy works best with, and how many contracts he trades at one time.

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Tim: Hello everybody. Thanks for joining me for another segment this week.

Today, we’re speaking with John Locke, and we’re talking about option trading with strategies he’s put together and things that he’s done that we’ve got upcoming here. And we’re going to talk to him about how he finds good opportunities in the option market. So, John, first of all, thanks for joining me over Skype today.

John: Thanks, Tim. I appreciate it. Thanks for interviewing me.

Tim: All right, great. So we should probably start off working out the type of option trader you are. Do you use spreads, strangles, straddles? How would you kind of classify your option trading?

John: Well, what I mainly trade is butterflies. I trade market-neutral positions with butterflies, and I hedge them in certain manners.

Tim: All right. When you say market-neutral, what does that mean?

John: Well, what it means is I can pretty much do the same trade month after month, and I can enter it regardless of market conditions, and I’m completely unconcerned about market direction.

Tim: Well, that’s always nice to have a trading strategy and to not have to worry about being right on the direction, just what happens. Well, describe for us what a butterfly is in garden-variety terms, if you would.

John: Yeah. If you do any kind of options strategies…if you do an iron condor, it would be an iron condor with a short strike at the same strike. If you’re a vertical spread trader, you could define it as selling a vertical spread and then buying a vertical spread with the same short strikes.

Tim: OK. I think most option traders that first start getting into this are just buying puts and calls outright as a strategy. But it seems most successful option traders that have been doing this for a long time very quickly stop that and get into some sort of spread type of trading. Would you agree with that?

John: Yeah. I mean, spreads have a much higher probability than simply buying a put or a call. I mean, if you buy a put or a call, you have to be right on direction and you have to be right on timing.

If you turn that into a spread trade, then you don’t have to be right on either. In other words, you have one scenario where you lose with the spread trade. You only have one scenario where you would win with a single call or put option.

Tim: Right. So you’ve got to be right in the correct amount of time and there are a lot of things that have to go in your favor if you’re just buying a put or a call outright.

John: Right, that’s correct.

Tim: All right. So give me maybe a recent trade that you’ve done, if you can describe what it was or how that all worked. I always like to ask about a recent trade, because this gives us a good example of the type of trading that you do. Do you have one recently that you did that worked out well for you?

John: Yeah. Like I said, I do the same thing month after month. Basically, if you look at this, this strategy is called an M3 strategy and it’s a butterfly that’s put on behind the market.

So, by that I mean, if the Russell is at 720 for example, I’ll put on a butterfly somewhere around 700 or 690 and I’ll hedge that position off. We do this somewhere around 50 days before expiration, and over time that position gains value. I’ll just watch my risks throughout the position. And then we take it back off.

So I’d say every month for the last three months, it’s been wonderful. We’ve just put the trade on, and we’ve made our adjustments and taken off at the profit target.

Tim: Is this something you could do for a living, or is this strategy more of kind of supplementing a job income that you’ve already got?

John: Well, what I love about this strategy is it controls your risk extremely well, and it adapts to most market conditions, which means that you could very conceivably turn this into a full-time career by trading this way. In addition, the strategy itself doesn’t require constant monitoring, so you can be out doing things while the position is working for you, which is extremely nice.

Tim: Right. That works for me, because I’ve always told people that my style of trading means I put on a trade and walk away from it. Because if I sit there in front of the screen, I start to fiddle with it, I start to move things around, and it usually sabotaged whatever idea I had in the first place. That’s certainly attractive to me, so I get that.

John: Yeah, yeah. It’s attractive to me too, because my dad always said I was lazy, but that’s not the truth. I’m very active, I like to do a ton of things, I just don’t like to sit and work.

Tim: Right.

John: This trading style complements me very well.



Tim: Right. Well, how did you come about this strategy? Is it something you did through trial and error? You learned from somebody else? How did you figure it out?

John: Mainly through trial and error. And as they say, when you try to help other people, you learn more than you do doing stuff on your own. One of the things I do is coaching and mentoring with options traders, and a lot of it came about by trying to get people profitable and just try and create techniques.

Some people are very good at calling market directions, some people aren’t, and some people are wrong all the time with market direction. The good part about this is in trying to develop something where people can become profitable without having to pick market direction, it kind of just pushed me into this, and it’s worked out very well.

Tim: What, typically, in terms of the number of contracts did you put on each side of this? What’s typical for you?

John: I usually like to run in the 40 to 50 range in the Russell. That’s a position that would be about $250,000, and that’s a type of trade…if you had that, you’d have a profit target of around $25,000.

Tim: Let me ask you about that profit target. How do you know where to set that each month when you put this on?

John: I have a strict plan that I follow as far as risk management and position size. So for example, if I did this with one Russell contract, I’d plan on putting $5,000 in the trade and I would plan on making $500 in the trade. On the flipside, if I were to lose for whatever reason, if I get down $500, I’m pretty much going to close on the position and then go on to the next month.

Tim: All right. This is done mostly on the Russell index, or indexes in general? Do you ever do it on individual stocks?

John: It can be done on Russell, on SPX. I have people doing it on both indices in very large amounts. You can do it on selected stocks…it depends on how the pricing of the options are. You’ll know as soon as you set it up whether it’s going to work or not.

Tim: Meaning what? It either begins to work in your favor right away or not?

John: Well no, no, no. What’s going to happen is…we have this analysis graph that we look at, like if you use a software such as Option View or if you’re using a broker like Thinkorswim, they have an graph that you can look at your position and how it makes money.

If I can’t get the right picture, then it’s just not going to work for me. If I determine the strikes are not available on a certain stock, then I have to say that’s not going to work for me.

But if I can get the right picture in my analyze graph and I have an adequate amount of strikes—and of course, a stock has to be priced high enough. You’d want to do this with something over $500 probably in price. You wouldn’t be doing small stocks, because commissions will eat you up.

Tim: Right. OK. Now let me ask about weekly options. Do you do this at all with weeklies, or is it just the standard options?

John: Well this particular trade, I don’t do with weeklies. I mean, I will bring this trade into expiration. I do have other strategies that I use with weeklies as well as something like this. This is a longer-term, slower-moving trade where I don’t have to watch. And the weeklies become a lot more sensitive to price movement, so you have to be a little bit more on top of those.

Tim: You brought up a good point about letting it go into expiration. How often do you do that versus closing it out once you’ve made a profit?

John: Right. Well, my determination of how far I will take this into expiration is completely dependent on what I call how safe the position is. So the great thing about this position is I can maintain a very safe position relative to price movement.

I have this position on now, for example, where I can take a price movement in the up direction forever. I mean, price can go as high as $20,000 and it wouldn’t be a problem for me.

On the downside, I usually almost have enough room of 60 or 70 points to the downside before I run into too much trouble, and even then I can make adjustments to extend that range very easily and methodically, where I very rarely would have a downside problem.

So as long as I can kind of keep that profile, I can bring this right into expiration day without a problem. If I get to the point where I start to take on too much risk in one side or the other, then I’m just going to pull the trade. This trade is all about controlling risk.

Tim: Is it ever a point where you would take off part of the position on either side and let some of it run?

John: Well, it’s really not on either side here. Like I said, the butterfly is behind the market, and then I have hedging to the upside. So you’d have to see how it looks exactly.

In other words we enter this trade, it’s going to be a butterfly with a call, but we’re constantly moving it around…as far as not just moving a butterfly around, but we’re turning the butterfly into a broken-wing condor, we’re moving longs, we’re adding longs, you know, whatever we need to do to control our risk and control our T plus zero profile on our graph.

So to answer your question is, yeah, sometimes I’ll scale my size down, but we’re always going to move the position around if we happen to take on risk in any particular location we’re not happy with.

Tim: Right. All right. So it does take some monitoring, just not intraday, minute-by-minute monitoring of the position?

John: Right, right. I mean, the good thing about this is that your risk is so under control that if you were to check this once a day…I’ve been trading pretty much the same strategy here since 2006, and I can’t think of a day even through the 2008 crash where I had to come in midday and do something with it.

Tim: OK. I think that’s—

John: I usually, I mean you should monitor it once a day, of course, to see if you start to take on too much risk and decide if I want to do something with it. But as far as sitting there all day, it’s just not necessary.

Tim: How much do the option Greeks play into what you’re looking at—theta, delta, all of those things—when you’re either putting on the position or monitoring it as it’s in?

John: Right. We’re always aware of our Greeks because they’re telling us what our risk is.

Tim: Talk about an example of how you use them. What’s most important to you? Which one?

John: OK. So actually, it’s the combination of them, and as far as that goes, our most important Greek isn’t even a number that you can see on the chart.

Our most important Greek as it relates to price movement is something that I call gamma trend. By that, I mean how fast does your delta change with price movement, and in which direction does it change with price movement?

I mean, we are concerned about delta, and we have delta limits, but realistically our delta can become pretty much irrelevant if our gamma trend is very favorable. And if we get any kind of a price move, and our delta shaves off to zero really quickly, then the delta is not that much of a concern.

So we’re looking at delta. We’re looking at gamma trend. We’re always looking at volatility and making sure that depending on where we’re positioned that we’re negative vega in the trade—it’s a negative volatility trade—and we’re just kind of taking all that into account and looking basically at the picture of our T plus zero line, which is going to tell us our gamma trend, and determining if that’s going to be a problem for us with price movement.

Tim: Well, John, we’ve kind of just scratched the surface here. You’ve got a Web site, Locke In Your Success. Is that the correct URL? Did I get that right?

John: Yeah. It’s, and Locke is spelled L-O-C-K-E like my last name.

Tim: All right. You’ve got something you’re doing for SMB Capital, which we’ve interviewed their traders quite a bit here in the past. When that Web site is ready, we’ll link to that in the notes for the transcript. John, any other last words here for our listeners? Any other things that we should know about?

John: Well, like I said, we have this M3 program, which is a trade I’ve been doing for years. I used it to mentor my trading students to help control risks in their positions. That’s going to be coming out, a whole program on exactly how that works.

So look for that in the future. It’ll be out very shortly. I think it will greatly improve any market-neutral trading strategy.

Tim: All right, great. Well listeners, we’ll link to that as soon as that’s available for you. John, thanks very much for your time today. I appreciate it.

John: You’re welcome. Thank you, Tim, and be careful out there trading everybody.

Click here for a .pdf version of the full transcript for this interview