Expanding the 1-2-3 Iron Butterfly

06/12/2013 7:00 am EST

Focus: OPTIONS

Michael Thomsett

Founder, Thomsett Publishing Website

Option traders often have “orphan” positions that are left over after all of the profits have been taken from existing trades, and Michael Thomsett of ThomsettOptions.com offers a solution for that problem.

Last month I visited with my son in South Carolina for a few days. As always, our discussions included options trading, and I walked him through the 1-2-3 iron butterfly and its hedge matrix. He grasped the potential of this strategy at once.

For many traders, the biggest issue is what to do with the “orphan” positions that are left over after all of the profits have been taken. In some cases, I have been able to close all options at a profit, but in others a few are left over and expiration is approaching. In these cases, I roll them forward into later-expiring positions, what I call a “reconstituted” 1-2-3 iron butterfly. I often am able to do this in approximately the same price range as the original, but sometimes price has moved enough that I have to employ a different range of strikes.

My son took this a step beyond my explanation and invented a new term, the progressive hedge matrix. Wow, I thought as soon as he explained this to me, this really brings the strategy into a dynamic and living application. Under the progressive version, I am able to not only roll any losses forward to new positions, but also to roll the strike ranges up or down depending on the direction of price movement in the underlying. Because you do not hold shares of the underlying, it does not matter which strikes are used. In strategies like covered calls, you can't go below your net basis because exercise creates a loss. But in the 1-2-3 iron butterfly, you can “range out” in either direction, and you can repeat this indefinitely.

For example, the initial 1-2-3 involves strikes of 50, 57.50, and 60. Stock price moved up into the mid 60s, so you take profits where possible and roll and paper loss positions into a reconstituted hedge matrix using 62.50, 65, and 67.50 strikes. Next time, the stock declines down to the high 40s, so you again roll into new positions based on 47.50, 50, and 52.50. During this discussion, held over breakfast at IHOP, we also talked about the expansion potential in the number of options used. Starting with 1-2-3, the progressive hedge matrix could be reset at 2-4-6 (same ratio of options but more positions and a higher net overall credit as well). Depending on the degree of price movement and volatility involved, you could reset to 1-2-3, keep it at 2-4-6, or even progress onward to 3-6-9. For most traders, even the limited margin requirement of the 1-2-3 may become expensive when dealing with sets of nine options positions; but the possibility is there.

This is not just a numbers game. The three-strike set of 1-2-3 always creates a net credit when the first and third month contain middle shorts with out-of-the-money longs (puts below and calls above); and the middle strike is the reverse). I have opened and managed several 1-2-3 iron butterflies in the virtual portfolio and am yet to take a loss. As long as you are willing to take small profits when they appear, and to patiently wait for positions to become profitable (from increased intrinsic value in the long side, or from loss of time value on the short side), you can make profits in the 1-2-3, as well. Most of these positions have ended up with those small number of orphans, but these can be rolled forward and absorbed effectively.

I have been pleasantly surprised at how consistently profitable this strategy has been, and it has become one of the two strategies I find to be both effective and profitable (the other being the dividend collar).

By Michael Thomsett of ThomsettOptions.com

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