Does anyone here have experience (or work with a firm with experience) using butterfly spreads? Interested to know what kind of cost (initial outlay) is involved, and whether this is directly comparable to the risk free rate.
Obviously the range across which options are spread and volatility of the underlying will affect the cost, but wondered if there is a sort of “rule of thumb” that can be applied to estimate the setup costs?
This isn’t really anything to do with the exam, more just out of interest (if the cost was indeed less than the sum of lending rate on secured loans plus purchase of a put option on the underlying, then this strategy could provide a great core to an absolute return strategy)
I would suggest as an additional resource, looking at Tasty Trade option strategies. They have an excellent trade platform and educational resources.
I trade options a bit but use a similar strategy with iron condors. The one thing you are not considering is the commission on four option legs. You need to have a good understanding of implied volatility and implied volatility rank. You need to consider collateral with credit spreads too.
if you are looking at sizing your position, kelly criterion can be useful.
From what assume, you are talking about the pricing of options in relation to the interest rate?
When interest rates are higher call options prices are higher
when IR (interest rates) are higher opportunity costs of holding
money is higher. By using call options investors save more money by not
paying for the underlying until later date and earn higher interest
The higher the interest rate you can earn on the cash you will use to
make that purchase, the greater the benefit of being able to delay that
When interest rates are higher put options prices are lower
when IR are higher opportunity costs of waiting is higher because investors lose more interest while waiting to sell the underlying when using puts.
the higher interest rate you can earn on the cash generated from that sale, the less desirable it is to delay that sale.
Thanks @rsparks – yes, understand the concepts behind pricing and have a fair bit of experience with commissions for retail-sized trades, suppose was more thinking of what the rates look like at a wholesale level. Specifically if the equivalent interest rate was at the risk-free rate it must be lower than the retail borrowing rate. Given the protection costs for most investors tend to be >1.5% above the retail lending rate, which for most Australian banks tends to track at around >2.3% over the risk-free, that would suggest that using options to establish the position is in the order of 3.8% less expensive that what is currently offered to retail investors, or 2.5% less expensive after my fee 🙂
Haven’t heard of iron condors before – had to Google that one! 🙂
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