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Straight From The Source

Tuesday, 3 Mar 2009 | 9:24 AM ET

One of the things I like to do most following our weekly broadcast is read and answer your emails. This week, Ray in Maryland wrote the following: Great show on Friday night!!!

Stacy said her DNA March 90-95-100 Call Butterfly would collect 1.00 and risk 4.00. I think she would have paid 1.00 to buy that butterfly, risking 1.00 for a potential reward of 4.00 if DNA does land at 95 by March expiration. Did I miss anything?

Well Ray, I reached out to the source, and below is Stacey's answer to your question.

Thank you for your continued support of our show.

The beauty of the "Options Action" blog is the opportunity it offers me and other guests to elaborate and correct on comments from the show. With my discussion of the DNA March 90-95-100 call butterfly, I discussed the risks of the trade as if it were sold yet made a “teepee payoff diagram” with my hands for a position in which the butterfly was bought. Given the viewer questions we have received as it relates to how we come up with our comments like “the options market is suggesting a 20% probability the stock increases 20% in the next month”, I wanted to take a minute to elaborate on the DNA discussion as it directly relates to these comments.

In the DNA trade, the March 90-95-100 call butterfly traded ~$1.00 (investors buy 1 March 90 call, 1 March 100 call and sell 2 March 95 calls and pay $1). The payoff diagram (drawn below) is an upside down V with the vertex at $95 and then flat lines extending for the upside down V starting at $90 on the downside and $100 on the upside – looking something like a butterfly, hence the name.

In this strategy, the investors paid $1 with a maximum profit of $4 if the stock were to close at $95 on March expiration. The risk is the $1 the investors paid which they would lose if the stock finishes below $90 or above $100. The reward is $4 which the investors would capture if the stock closed at the strike that they have sold 2 calls, in this case $95. What makes this type of trade so interesting is that the investors profit the most when the stock finishes at an exact point at expiration, in this case $95. Said another way, the investors are paying $1 to win $4 that the stock finishes at $95 at March expiration. Paying $1 to win $4 is another way of saying 1:4 in odds terms, or 20%. While it is not exact, a “back of the envelope” analysis of this March 90-95-100 butterfly trading $1 is to say that investors believe there is at least a 20% probability that the stock will finish around $95 at March expiration.

With these butterflies, we can then extrapolate what the probability of a stock to finish at each strike by that expiration is. This type of analysis is how we interpret the market’s implied probability distribution for any time period, bearing in mind that the markets are always changing, so this distribution is also changing.

Stacey

Questions, comments send them to us at: optionsaction@cnbc.com

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