001

Table of Contents
 
Praise
Also by ANTHONY J. SALIBA with Joseph C. Corona and Karen E. Johnson
Title Page
Copyright Page
Important Disclosures
 
Table of Figures
Acknowledgements
Introduction
Chapter 1 - Strategies for the Directionless Market
 
WHAT IS A DIRECTIONLESS MARKET?
IDENTIFYING THE DIRECTIONLESS MARKET
PROFITING FROM A DIRECTIONLESS MARKET
OPTION STRATEGIES TO ADDRESS THE DIRECTIONLESS MARKET
SUMMARY
 
Chapter 2 - Long Butterfly Spread Basics
 
THE CALL BUTTERFLY
THE PUT BUTTERFLY
P&L BEFORE EXPIRATION AND UNDER CHANGING MARKET CONDITIONS
CALL BUTTERFLY OR PUT BUTTERFLY?
SUMMARY
CHAPTER 2 EXERCISE
CHAPTER 2 QUIZ
 
Chapter 3 - Long Condor Spread Basics
 
THE LONG CALL CONDOR
THE LONG PUT CONDOR
CALL CONDOR OR PUT CONDOR?
SUMMARY
CHAPTER 3 EXERCISE
CHAPTER 3 QUIZ
 
Chapter 4 - The Greeks
 
LONG CALL BUTTERFLY AND CONDOR PLACEMENT
PRICING MODELS
THE GREEKS
THE GREEKS: SUMMARY
CHAPTER 4 EXERCISE
CHAPTER 4 QUIZ
 
Chapter 5 - Application of the Greeks
 
INTUITING THE GREEKS
THE GREEKS
SUMMARY
CHAPTER 5 EXERCISE
CHAPTER 5 QUIZ
 
Chapter 6 - Understanding Iron Butterflies and Condors
 
COMPARING LONG CALL AND PUT BUTTERFLIES AND LONG CALL AND PUT CONDORS
GUTS
THE CLASSIC LONG IRON BUTTERFLY
THE INTEREST IMPACT
TRADING THE IRON BUTTERFLY
SUMMARY
CHAPTER 6 EXERCISE
CHAPTER 6 QUIZ
 
Chapter 7 - Popular Mutant Structures: Broken-Wing Butterflies, Pterodactyls, ...
 
THE BROKEN-WING BUTTERFLY
THE BROKEN-WING CONDOR
MOTIVATIONS BEHIND THE TRADE
PTERODACTYLS (IRON AND OTHERWISE)
IRON PTERODACTYL
SUMMARY
CHAPTER 7 EXERCISE
CHAPTER 7 QUIZ
 
Chapter 8 - Strategy Application
 
LONG BUTTERFLY AND CONDOR TRADING STRATEGIES
COMMON TRADING SCENARIOS
IRON BUTTERFLY TRADE APPLICATION
SUMMARY
CHAPTER 8 EXERCISE
CHAPTER 8 QUIZ
 
Chapter 9 - An Interview with Anthony J. Saliba
 
Q&A
Appendix A
Appendix B
Index
About the Authors
About Bloomberg

Table of Figures
 
Figure 1.1 Consolidation
Figure 1.2 Seasonal Sideways
Figure 1.3 Support
Figure 1.4 Resistance
Figure 1.5 Trading Range
Figure 1.6 Time Decay
Figure 1.7 Theta Over Time
Figure 1.8 Long Butterfly Payout
Figure 2.1 Structure of the Long Call Butterfly Spread
Figure 2.2 Long Call Butterfly Decomposition Diagram
Figure 2.3 Long Call Butterfly P&L Diagram
Figure 2.4 P&L Diagram of the Long XYZ April 95/100/105 Call Butterfly Source: Corona Derivatives, LLC
Figure 2.5 Structure of the Long Put Butterfly Spread
Figure 2.6 Long Put Butterfly Decomposition Diagram
Figure 2.7 Long Put Butterfly P&L Diagram
Figure 2.8 P&L Diagram of the Long XYZ April 95/100/105 Put Butterfly Source: Corona Derivatives, LLC
Figure 2.9 Option Price Chain for XYZ
Figure 3.1 Structure of the Long Call Condor Spread
Figure 3.2 Long Call Condor Decomposition Diagram A
Figure 3.3 Long Call Condor Decomposition Diagram B
Figure 3.4 Long Call Condor P&L Diagram
Figure 3.5 P&L Diagram of the Long XYZ April 95/100/105/110 Call Condor Source: Corona Derivatives, LLC
Figure 3.6 Long Put Condor Spread Structure
Figure 3.7 Long Put Condor Decomposition Diagram A
Figure 3.8 Long Put Condor Decomposition Diagram
Figure 3.9 P&L Diagram of the Long XYZ Put Condor
Figure 3.10 P&L Diagram of the Long XYZ 95/100/105/110 Put
Figure 3.11 Trading Range
Figure 3.12 Butterfly-Condor Comparison
Figure 3.13 Option Price Chain for XYZ
Figure 3.14 Option Price Chain for XYZ
Figure 4.1 Long Butterfly Spread vs. Time
Figure 4.2 Call Delta vs. Underlying Price [Strike = 100]
Figure 4.3 Put Delta vs. Underlying Price [Strike = 100]
Figure 4.4 Call Delta vs. Implied Volatility [Stock price = 100; 90 days to
Figure 4.5 Gamma vs. Time to Expiry [Stock price = 100; implied volatility = 0.50] Source: Corona Derivatives, LLC
Figure 4.6 Gamma vs. Strike Price [Stock price = 100]
Figure 4.7 Gamma vs. Implied Volatility
Figure 4.8 Vega vs. Time to Expiry [Stock price = 100]
Figure 4.9 Theta vs. Time to Expiry [Stock price = 100]
Figure 5.1 Butterfly Delta vs. Price and Time
Figure 5.2 Condor Delta vs. Price and Time
Figure 5.3 Butterfly Delta vs. Price and Volatility
Figure 5.4 Butterfly Gamma vs. Price and Time
Figure 5.5 Vega vs. Time to Expiry [Stock Price = 100]
Figure 5.6 Butterfly Vega vs. Time
Figure 5.7 Butterfly Vega vs. Implied Volatility
Figure 5.8 Butterfly Theta vs. Days to Expiry
Figure 6.1 Overlapping Bull and Bear Spreads Form Long Call and Put Butterflies Source: Corona Derivatives, LLC
Figure 6.2 Adjacent Bull and Bear Spreads Form Long Call and Put Condors Source: Corona Derivatives, LLC
Figure 6.3 Bull Call Spread = Bull Put Spread
Figure 6.4 Bear Call Spread = Bear Put Spread
Figure 6.5 Long Call Butterfly = Long Put Butterfly
Figure 6.6 Long Call Condor = Long Put Condor
Figure 6.7 Long Guts Iron Butterfly
Figure 6.8 Classic Long Iron Butterfly
Figure 6.9 Long Guts Iron Condor
Figure 6.10 Classic Long Iron Condor
Figure 6.11 The Long Box Spread
Figure 6.12 The Short Box Spread
Figure 6.13 Long Call Butterfly and Classic Long Iron Butterfly Comparison Source: Corona Derivatives, LLC
Figure 6.14 Long Iron Butterfly
Figure 6.15 Long Iron Butterfly With Prices
Figure 7.1 Structure of the Long Broken-Wing Call Butterfly
Figure 7.2 Structure of the Long Broken-Wing Put Butterfly
Figure 7.3 Long Broken-Wing Call Butterfly P&L Diagram
Figure 7.4 P&L Diagram of the Long XYZ 95/100/110 Broken-Wing Call Butterfly Source: Corona Derivatives, LLC
Figure 7.5 Long Broken-Wing Put Butterfly P&L Diagram
Figure 7.6 P&L Diagram of the Long XYZ 95/105/110 Broken-Wing Put Butterfly Source: Corona Derivatives, LLC
Figure 7.7 Structure of the Long Broken-Wing Call Condor
Figure 7.8 Long Broken-Wing Call Condor P&L Diagram
Figure 7.9 Diagram of the Long XYZ April 95/100/105/115 Broken-Wing Call Condor Source: Corona Derivatives, LLC
Figure 7.10 Structure of the Long Broken-Wing Put Condor
Figure 7.11 Long Broken-Wing Put Condor P&L Diagram
Figure 7.12 Diagram of the Long XYZ 95/105/110/115 Broken-Wing Put Condor Source: Corona Derivatives, LLC
Figure 7.13 Comparison of the Long Call Condor and Long Put Condor Structure Source: Corona Derivatives, LLC
Figure 7.14 Comparison of the Long Call Pterodactyl and Long Put Pterodactyl Structure Source: Corona Derivatives, LLC
Figure 7.15 Long Call Pterodactyl P&L Diagram
Figure 7.16 Diagram of the Long XYZ April 95/100/110/115 Call Pterodactyl Source: Corona Derivatives, LLC
Figure 7.17 Long Put Pterodactyl P&L Diagram
Figure 7.18 Long XYZ April 95/105/105/115 Broken-Wing Call Condor Diagram Source: Corona Derivatives, LLC
Figure 7.19 Long Iron Pterodactyl Decomposition Diagram A
Figure 7.20 Long Iron Pterodactyl Decomposition Diagram B
Figure 8.1 Long 95/100/105 Butterfly vs. Time
Figure 8.2 Long 90/95/100/105 Condor vs. Time
Figure 8.3 Long 95/100/105 Butterfly vs. Implied Volatility
Figure 8.4 Long 90/95/100/105 Condor vs. Implied Volatility
Figure 8.5 Sideways Market
Figure 8.6 Narrow Range of Profitability
Figure 8.7 Wide Range of Profitability
Figure 8.8 Declining Volatility Trading Range
Figure 8.9 Price Transition Trading Range
Figure 8.10 Price Rotation Trading Range
Figure 8.11 Bull Put Spread Evolution S
Figure 8.12 Bull Spread to Bear Spread Evolution
Figure 8.13 Bear Call Spread Evolution Source
Figure 8.14 Bull Put Spread Evolution
Figure 8.15 Bear Call Spread Evolution
Figure A.1 Trading Range
Figure A.2 XYZ Weekly Chart

PRAISE FOR OPTION STRATEGIES FOR DIRECTIONLESS MARKETS
Trading with Butterflies, Iron Butterflies, and Condors
by Anthony J. Saliba
with Joseph C. Corona and Karen E. Johnson
 
 
 
Option Strategies for Directionless Markets offers a practical approach to trading butterfly strategies. I found it very comprehensive. The what-if scenarios were especially helpful.”
—MATT BROWN
Sales Trader, Piper Jaffray
 
“With detailed and insightful discussions on strategy application and position management, this book offers a tactical approach—something I have not found in other books.”
—GÖRAN EKMAN
Head of Sales, Financial Training, OMX
 
“Change is constant—new and improved technology every day and market change continual. To keep up and gain an edge, the trading strategies and how-to approach detailed in Tony Saliba’s Option Strategies for Directionless Markets can take you to the next level of options professionalism.”
—KEN HEATH
Publisher, Traders Magazine

Also by ANTHONY J. SALIBA with Joseph C. Corona and Karen E. Johnson
Option Spread Strategies:
Trading Up, Down, and Sideways Markets
(Spring 2008)
 
Also available from
BLOOMBERG PRESS
 
New Insights on Covered Call Writing:
The Powerful Technique That Enhances Return
and Lowers Risk in Stock Investing

by Richard Lehman and Lawrence G. McMillan
 
Trading Option Greeks:
How Timing, Volatility, and Other Pricing Factors Drive Profit

by Daniel Passarelli
(Spring 2008)
 
Breakthroughs in Technical Analysis:
New Thinking from the World’s Top Minds

edited by David Keller
 
New Thinking in Technical Analysis:
Trading Models from the Masters

edited by Rick Bensignor
 
 
 
 
 
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This book is available for bulk purchase at special discounts. Special editions or chapter reprints can also be customized to specifications. For information, please e-mail Bloomberg Press, press@bloomberg.com, Attention: Director of Special Markets or phone 212-617-7966.

001

Important Disclosures
Following are several important disclosures we are required to make according to the rules of the Chicago Board Options Exchange (CBOE), by which we are governed. We encourage you to read them.
• Prior to buying or selling an option, one must receive a copy of the booklet “Characteristics and Risks of Standardized Options.” Copies of this document are available at www.theocc.com/publications/risks/riskchap1.jsp or from International Trading Institute, Ltd., 311 South Wacker, Suite 4700, Chicago, IL 60606.
• Options involve risk and are not suitable for all investors.
• In order to trade strategies discussed in this book, an individual must first have his account approved by a broker/dealer for that specific trading level.
• No statement in this book should be construed as a recommendation to purchase or sell a security or as an attempt to provide investment advice.
• Writers of uncovered calls or puts will be obligated to meet applicable margin requirements for certain option strategies discussed in this book.
• For transactions that involve buying and writing multiple options in combination, it may be impossible at times to simultaneously execute transactions in all of the options involved in the combination.
• There is increased risk exposure when you exercise or close out of one side of a combination while the other side of the trade remains outstanding.
• Because all option transactions have important tax considerations, you should consult a tax adviser as to how taxes will affect the outcome of contemplated options transactions.
• The examples in this book do not include commissions and other costs. Transaction costs may be significant, especially in option strategies calling for multiple purchases and sales of options, such as spreads and straddles.
• Most spread transactions must be done in a margin account.

Acknowledgments
I would like to thank the many individuals who helped make the writing of this book possible.
First I would like to thank my coauthors, Joe Corona and Karen Johnson. Realizing the need for an educational tool focusing on strategies that can be used to take advantage of a sideways market, Karen came up with the idea to write a book about the butterfly strategy and its affiliates. Joe Corona brought his trading expertise and writing skills to the table. The book would not have been possible without their dedication to this project.
I would also like to thank David Schmueck, my firm’s registered options principal. He went beyond the call of duty in helping us edit and proofread the book. His input was very helpful in making sure the book’s content was appropriate for the intended audience.
Stephen Isaacs of Bloomberg Press was a champion in publishing this book, as was my agent Cynthia Zigmund.
Lastly I would like to thank Chris Hausman, Scott Mollner, Carolyn Corona, and Christine Fisher for their help in proofreading portions of the manuscript. Their insights and suggestions were invaluable.
002
Anthony J. Saliba
Founder
International Trading Institute

Introduction
For options traders, these are the best of times. A “perfect storm” of technology and competition has eroded the traditional advantages of access, information, and cost enjoyed by market makers and other professionals. These changes in the industry have helped open the door to the individual to participate in the options market in ways that would have been practically impossible just a few years ago.
Options can now be priced, executed, and managed electronically using many trading platforms, and these same technological advances have allowed brokers to reduce their commissions dramatically. Penny pricing and portfolio-based margining may serve only to further level the playing field.
Innovations at the exchange level allowing the electronic matching and processing of complex orders have stimulated greater participation and thus greater liquidity in these types of structures. Strategies that were previously “untouchable” by the individual investor may now be within reach, allowing the individual to express complex market views involving direction or lack thereof, timing, magnitude, velocity, and volatility levels.
In our first book, The Options Workbook, 3rd Edition (Dearborn Publishing, 2004), we introduced the entire options strategy toolbox. In this book, we explore strategies that address a directionless or sideways market: the butterfly and its variations, including the iron butterfly, condor, broken-wing butterfly, and pterodactyl.
We introduce the basics of long butterfly spreads and long condor spreads, including structure, P&L diagrams, and various scenarios. We also take a look at the Greeks (delta, gamma, theta, and vega) to see how they are used to measure the sensitivity of an option to changing conditions—a key factor in understanding long butterfly and condor spread structures. In later chapters, we explore using the butterfly structure as a trading vehicle for more aggressive trading tactics.
A detailed discussion on strategy application and position management is offered for each structure. Numerous charts and graphs help illustrate key concepts throughout each chapter.
It’s one thing to read about these structures and strategies, but it’s quite another to implement them in your own trading. So, at the end of each chapter you will find exercises and a quiz to test your understanding of the concepts presented. There is a final exam in the back of the book to further test your comprehension of the material covered.
You may also wish to check out our website, www.itichicago.com, for additional option strategy discussions.

1
Strategies for the Directionless Market
Options continue to grow in popularity with investors. According to the Options Industry Council, volume in 2006 grew 34.8 percent over 2005, with more than two billion contracts traded. Investors are realizing that options can be profitable components of their portfolios and may offer some advantages over outright stock positions.
One of the many possible advantages of using options is the ability to build a custom strategy to fit a particular market view or situation. One does not need to be restricted to “bullish” or “bearish” in order to profitably participate in the marketplace. Market views encompassing direction (or lack thereof), magnitude, velocity, timing, and volatility all can be traded using option combinations or spreads that fit a specific market situation.
One of the most common market conditions that force the bulls and the bears to the bench is the “directionless” or “sideways” market. To a directional trader, a directionless market is a curse, where one continually gets whipsawed and forced out of the market as it bounces up and down but ultimately goes nowhere. However, to the option trader this situation can be quite profitable if the right strategy is applied.

WHAT IS A DIRECTIONLESS MARKET?

A directionless market occurs when the forces of supply (selling) and demand (buying) are not powerful enough to push prices into a directional trend. The market then begins to move sideways for a period of time. There is no “standard” length of time a market needs to go sideways to be deemed directionless; it is subjective and up to the observer. These sideways periods may form from a consolidation phase, where the market decides to take a “rest” after a directional move (see Figure 1.1), a waiting period before important data are released, a prelude to a reversal of trend, or a seasonal condition where there is just not enough interest or activity to force the market into a particular direction (see Figure 1.2).
Figure 1.1 Consolidation
Source: Corona Derivatives, LLC
003
Figure 1.2 Seasonal Sideways
Source: Corona Derivatives, LLC
004

IDENTIFYING THE DIRECTIONLESS MARKET

Directionless markets are identified by observing price action. Technical analysis tools can be especially helpful in identifying an underlying directionless stock or index. Bar charts, candlestick charts, Market Profile, and other types of graphic representation of price action over time can be used. In addition, technical indicators, particularly “strength of trend” indicators, can be employed to help identify situations where trend strength is low and a directionless market is likely to persist. One doesn’t have to be a technical wizard to spot a potentially directionless market. “Eyeballing” a price chart is usually sufficient, but there are a few basic concepts that should be understood.

Support and Resistance

Support and resistance levels represent price levels or zones where demand (buying pressure) or supply (selling pressure) materializes and halts falling prices or rising prices, respectively. Support and resistance levels can form within uptrends, downtrends, or directionless markets.

• Support

Support is a price level or zone located below the current market price where buyers become more willing to buy and sellers are reluctant to sell. The buyers overwhelm the sellers in or near these zones, forcing prices back up and preventing the price from falling below the support level. Support levels or zones are determined by connecting reaction lows or “valleys” of price action with a line. It takes at least two reaction lows near the same price to form a support level. The more reaction lows that occur in this area the stronger the support level is seen to be. Figure 1.3 illustrates this concept. The arrows identify the reaction lows which are then connected to form a support level.
Figure 1.3 Support
Source: Corona Derivatives, LLC
005

• Resistance

Resistance is a price level or zone located above the current market price where sellers become more willing to sell and buyers are reluctant to buy. The sellers overwhelm the buyers in or near these zones, forcing prices back down and preventing the price from rising above resistance. Resistance levels or zones are determined by connecting reaction highs or “peaks” of price action with a line. It takes at least two reaction highs near the same price to form a resistance level. The more reaction highs that occur in this area, the stronger the resistance level is seen to be. Figure 1.4 illustrates this concept. The arrows identify the reaction highs which are then connected to form a resistance level.
Figure 1.4 Resistance
Source: Corona Derivatives, LLC
006

The Trading Range Market

When the forces of supply and demand equalize, a stalemate occurs and the market moves sideways between support and resistance levels within a trading range until one side can build up enough strength to finally overwhelm the other. Visualize two opposing armies entrenched directly across the battlefield from each other with neither having enough strength to break through the front line of the other. Attacks by each side on the other’s front line are easily repulsed and neither side advances. The stalemate persists until one side finally builds up enough strength to break through the front line of the other. This is analogous to the classic directionless market (see Figure 1.5 below).
Figure 1.5 Trading Range
Source: Corona Derivatives, LLC
007

The Trend Is Your Friend (Even When There Isn’t One)

One of the oldest sayings in trading is “The trend is your friend.” In other words, it is best to trade in the direction of the prevailing price trend because even if the trader’s timing when entering a position is off a little bit, the underlying trend will eventually resume and come to the rescue. This, of course, doesn’t always happen because trends typically end. Markets may trend longer and further than most would believe; therefore, trading with the prevailing price trend generally may be a good idea. This also may be true of the directionless market. Even though it is sometimes referred to as a “trendless” market, the directionless market does have a price trend—sideways—and it is important to consider this trend as well. Indicators that measure the strength of a trend (or lack of it) also can be helpful in identifying or confirming directionless trade possibilities.

Using Technical Indicators

There are almost as many technical indicators as there are stars in the sky—and certainly too many to attempt to cover here. However, a certain class of indicators, strength of trend indicators, can be used in conjunction with price charts to help identify markets that are directionless and have low trend strength (and, therefore, are likely to remain directionless).
Some of the better-known indicators include J. Welles Wilder’s Average Directional Index (ADX) and Average True Range (ATR). Bollinger Bands and other volatility-based indicators also can be helpful in identifying low-volatility (directionless) situations. These and many other technical indicators can be found in most off-the-shelf technical analysis software packages. As with all technical indicators, it is important they be used with price charts for purposes of confirmation rather than on their own.

Important Factors

Regardless of what methods or tools are used to identify the directionless market, there are some important factors to consider when analyzing an underlying instrument for a possible directionless option strategy. Most important are the price levels involved. Support and resistance levels need to be identified, along with the point or area to where price tends to revert as it meanders up and down. These levels are of key importance for strike (exercise price) selection when constructing the strategy to be used. It also is important that the underlying instrument being analyzed appears likely to remain in the directionless mode for the period of time that corresponds to the time horizon the investor has chosen.

PROFITING FROM A DIRECTIONLESS MARKET

So what type of option strategies will theoretically profit from a directionless market? If a market is directionless and is hovering around the same prices every day or floundering inside a trading range, then the only thing really changing on a day-to-day basis is the passage of time. So it follows that those option strategies that are neutral in terms of direction and benefit from the passage of time (strategies with positive time decay) are the best for taking advantage of a directionless market.

Time Decay

The price of an option has two components: intrinsic value and extrinsic value. Intrinsic value is the amount by which an option is in-the-money. A call option is in-the-money if the price of the underlying is above the strike price. A put option is in-the-money if the price of the underlying is below the strike price. Any remaining value is extrinsic value. At-the-money options and out-of-the-money options are composed entirely of extrinsic value. The amount of extrinsic value in an option depends on many factors, including underlying price, interest rates, dividends, time until expiration, and implied volatility. The more uncertainty there is about the option’s possible value (for example, higher volatility, greater time to expiration), the greater the extrinsic value of the option. Conversely, the more certainty there is about an option’s value (for example, lower volatility, less time until expiration), the lower the extrinsic value of the option.
Figure 1.6 Time Decay
Source: Corona Derivatives, LLC
008
Theoretically, an option loses a portion of its extrinsic value every day, and, over time, an option will lose all of its extrinsic value. This is referred to as “time decay.” Because of time decay, buyers of options theoretically lose money every day, while sellers of options theoretically gain money every day. Time decay is quantified by theta (see Figure 1.6).

Theta

Theta is defined as the sensitivity of an option’s price to the passage of time. It is usually quantified as the loss in an option’s extrinsic value over one day’s time. Long options have negative theta, and short options have positive theta. Some other important characteristics of theta:
• Theta of at-the-money options is greatest
• Theta of at-the-money options rises sharply as expiry approaches
• Theta of in-the-money and out-of-the money options falls as expiry approaches
Looking at Figure 1.7