Advanced Stock Option Strategies
Adjusting a Directional Butterfly Option? When a Price Target Changes
By Frank Kneipher
Jan 12, 2007 - 10:05:00 AM

Adjusting a Directional Butterfly ? When a Price Target Changes

A few weeks ago in this column, we broke down a Directional Butterfly Strategy.  We illustrated the appealing potential it provided along with how the outcome can be impacted by simply tweaking the strike prices that were used while maintaining the same price target.  In the table below, with our price target for GOOG at 500, we can see that the range of profit is quite attractive.

As we can see in the table above, with our price target of 500, this trade has a nice range for profit allowing 13 points to the upside and 12 points on the downside.  As Option Strategist?s, we know that things can change and perhaps our opinion on GOOG will change along with our initial price target of 500.

Depending on our new outlook, we have several choices available to us in deciding how implement the adjustment.  The first thing that comes to mind would be to swap the original Butterfly with a new revised edition that reflects the new price target.  This can be done by completely closing all the original legs simultaneously and then simply enter into the new position.  The profit or loss on the original butterfly would depend on what GOOG might have done between the original entry and the change of opinion (price target) along with how much time has passed between two.  Remember that the butterfly is NOT vulnerable to moderate moves in the underlying.  In most cases we would expect to get out of the original butterfly at a price that is pretty close to the original cost, maybe a small profit or loss.  The important thing here is to get the new price target covered and be in position to profit on the new target.

Another method might be to adjust the butterfly into a VERTICAL SPREAD.  If we think GOOG is going to under perform and have trouble reaching 490, we can simply buy back 10 of the SHORT 500 Calls and sell all of our 490?s.  This would be done for a credit and leave us SHORT 10 of the 500 Calls backed up by our 510 Long position.  All said and done, we put ourselves in a trade that now makes a profit with GOOG staying under our new price target of 490 along with an attractive 10 point safety net all the way up to 500.

Of course we can use the same VERTICAL SPREAD method should our opinion (price target) be higher and we think GOOG is going to rally past 510.  That would be done by once again buying back 10 of the 500 Calls, only this time we will sell our 510?s.  We will be left with a 490/500 VERTICAL SPREAD on GOOG and the profit will max out with GOOG reaching our new price target of over 510.  The downside protection here keeps our SPREAD at +10 all the way down to 500.