CASE STUDY: EEM Sept 42 – 43.5 – 45 Call Butterfly Spread — *expired*

| August 9, 2012 | 0 Comments More

The largest options trades so far today are in the iShares Emerging Markets Fund (EEM). Shares are up 38 cents to $40.75 and a Sep 42 – 43.5 – 45 call butterfly trades on the ETF for 22 cents, 40000X electronically on ISE. Data from the ISE is reporting the fly was bought, to open; with the body being sold 80000X at 27 cents per contract. The hefty spread seems to be targeting a move to $43.5 through the September expiration, which represents a 6.7 percent advance in the emerging markets ETF over the next 43 days. Shares have already gained nearly 9 percent since 7/23. Let’s open this trade as a Case Study and also close the EFA Dec 53 Long Call Case Study today.

A call butterfly spread is a three-legged options strategy and is typically initiated when the strategist expects the underlying to trade in a range or if they are targeting a directional move higher. Like any butterfly spread, the position includes a body and two wings. When bought, the long call fly involves selling one strike for the body of the spread and buying (half as many) of a higher strike for one wing and a lower strike for the other wing. The price target is the middle strike or the body of the fly. You can consider the dynamics similar to buying a call spread and selling a higher strike put spread.

Deep out-of-the-money butterfly spreads can often be initiated for small debits, but have a smaller probability of success compared to an at-the-money or near-the-money fly. Any debit paid is at risk if shares hold below the lower wing of the spread and the calls expire worthless. There are two breakevens in the call fly (at expiration). The first is equal to the lower strike plus the debit and the second is the highest strike minus the debit. The range of profitability is between the two breakevens. The max potential profit is equal to the difference in the first two strikes minus the debit and happens if shares settle at the middle strike at the expiration. At that point, the first leg of the spread has intrinsic value but other two legs expire worthless.

In this case, shares are trading for40.75 and EEM Sept 42 – 43.5 – 45 call butterfly spread traded for 0.22. The risk to the trade is the debit paid, or0.22 if shares hold below the lower strike or rally dramatically beyond the higher strike, which represents gains of 3.07% and 10.4% above current levels. The first breakeven is equal to the lower strike price minus the net debit, or 42.22 and 3.61% from current levels. The second breakeven is equal to the higher strike price minus the net debit, or 44.78 and 9.9% from current levels. The max profits happen if shares rally to the middle strike, or 6.75% percent above current levels. The max profit equals the difference between the first two strikes minus the debit, or 1.28. The OptionsXpress payoff chart shows the risk-rewards and probabilities of success graphically.

Case Study-EEM Sept 42 – 43.5 – 45 call butterfly spread
Bias = Bullish
Risk = Debit=0.22
Reward=Diff in Strikes – Debit=1.28
Breakeven=higher strike-debit=44.78
Breakeven=lower strike + debit =42.22

Download PDF —> EEMdec4243545cf

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Category: All ETFs, Trading Education

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Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.

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