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Butterfly's are buzzing me around my head...

Butterfly's are my favorite options strategy as of late.

I spend several hours a day doing R&D around various strategies and had an "aha" moment a few weeks ago while looking at the effects of Implied Volatility (IV). Some options strategies are positively affected by increases in volatility if the value increase due to IV offsets theta, e.g., straight calls & puts and calendars if we get the direction correct and straddles/strangles for a non-directional play.

As discussed in my previous blog post, most stocks get a significant IV increase in their options leading up to earnings. Then - boom - IV crushes and their options lose significant value if the price movement of the stock doesn't offset the decline in value associated with vega.

Butterfly's gain value if IV crushes. So if we can find candidates that have a significant increase in IV prior to earnings and have a history of non-movement immediately following earnings, we can potentially profit.

Below is a case study of this type of trade on JPM, which announced earnings before market open on Thursday, October 12th last week:

(Courtesy of TomsOptionTools)

On earnings plays, I usually position size based on being willing to lose 100% of the trade. This means that I buy a significantly lower number of contracts as I don't have a stop. In the case of the above trade placed at the end of the trading day on Wednesday, October 11th, I bought five JPM October 13 $98.50 puts, sold ten JPM October 13 $96.50 puts, and bought five JPM October 13, $94.50 puts for a net debit of $0.63. This created a butterfly that would profit on sideways movement. My expectation was that JPM would not move significantly in price and IV would crush after earnings release before the market open on October 12th.

Indeed, my prognosis was correct and JPM declined only 0.88%. IV also dropped and enhanced my profitability.

(Courtesy of TomsOptionTools)

Ultimately, I exited the above trade for $1.14, just over 80% ROI.

I have a number of candidates for this earnings season that I have been able to identify and back test through TomsOptionTools. They will be discussed in an upcoming course offered through on Basic Options Strategies.

Disclaimer: This strategy does not work on all stocks. Please do your own TA and due diligence.