Traders Ask: What Do I Do About An Obnoxious Bid Ask Spread on a Butterfly Trade?

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An Options Tribe Member  asks:

Given that we’re about 55 days out from the  July monthly options expiration,  I was playing with a July 770-820-870 put butterfly on the RUT (when it was trading around 840).  Usually the bid/ask spread for ATM and OTM puts on the RUT is narrow enough, but the spread on the 870 put ($51.80 by $54.50) is horrendous.  I think the bid/ask quotes on the entire fly was around $9.20 by $15.00- quite large to say the least.  So it seems to me for a play like this to work you’d have to get pretty good execution.

Since John (the writer is referring to John Locke who presented this butterfly trade  at our first Tribe meeting this past Monday)  has traded this for a while now I was curious to see he deals with the order entry.  Is he placing his limit order half way between the bid and ask?  How much of a discount has he been able to get on average off the ask price?

Great question. I’ve traded this particular strategy many times myself and I would generally say that, with few exceptions, we are able to get hit at better than mid-prices about 50% of the time, particularly  if we are patient and allow the market to move around a little bit until it finally hits our preferred price. Having said that I’d also say that over time we have found the $RUT to be a bit more difficult to trade from an execution standpoint. As for the other half of the time, we will have to accept mid-prices and perhaps a bit  greater than mid-prices, to complete the trade, particularly in swift  moving markets.

I also gave John a call after I received your inquiry to see what he thought and he made a great point. While he agreed with my general thinking as to the probability of being able to get executed  right around mid-prices, he made another suggestion which I thought was excellent.  If the trader is uncomfortable with the wide bid-ask  spreads when a deep in the money option is involved, why not place the trade as an iron butterfly? Then the trader will have no deep in the money options in the trade initially and therefore a better shot at a more reasonable bid-ask spread for the entire butterfly structure. I compared the two spreads just now and while the mid-prices were very close, the iron butterfly’s bid-ask spread was almost 50% thinner than the same spread on the put-side only butterfly! That’s impressive.

That is not to say that the iron butterfly execution price will necessarily be much better than the put-side only butterfly, but if the trader is uncomfortable with the bid-ask spread then the  iron butterfly looks like a really solid solution.

This is a good example of the value of an options community. We can help each other to solve problems and in the process raise intellectual issues that we can then apply to other trading situations. In short, we grow from working with each other.

Next meeting of the Tribe is Wednesday May 25 at 5pm EST. Hope to see you there!

Seth Freudberg

Director,  SMB Options Training Program

The SMB Options Training Program is a program designed for novice and intermediate level options traders who are seeking an intensive training process to learn how to trade options spreads for monthly income. For more information on this program contact Seth Freudberg: [email protected].


5 Comments on “Traders Ask: What Do I Do About An Obnoxious Bid Ask Spread on a Butterfly Trade?”

  1. Most of the width of the 870 put is because of delta risk.  In general, bid-ask width is a function of risk.  For an options market maker, two of the most important risks are delta and vega, or volatility risk.  The butterfly significantly reduces the delta risk, but is still quoted as the sum of 4 options’ spreads.

    You could probably trade all you want at roughly 1.00 around the 12.10 midpoint.  As a former options market maker on the CME floor and electronically on the ISE, I can tell you that I’d usually be happy to trade this at my theoretical value (~ midmarket) if it reduced my inventory.

    Trading the iron fly is a great suggestion; I’d also recommend checking the call fly if it seemed like you were giving up too much with the put fly.  Sometimes an equivalent bid in the other option will attract a more willing counter party.

  2. I also like to trade Butterflies on the RUT so this question got my interest as I often wondered the same and thanks Seth and Ed618 for the responses.

    I also recently started to prefer the Iron Butterfly as well for liquidity purposes. When I started one thing I forgot to look at was Open Interest. When putting on a ATM or slightly OTM 40-wide Butterfly I noticed that some of the further strikes in/out of the money on a straight call or put butterfly only had a couple hundred contracts in open interest comparing to thousands in the opposite call or put chain. So this was another factor for me preferring the Iron Butterfly now.

  3.  Great input Ed.  When John and I talked we discussed  the merits of looking at all three: the put-side/call-side/iron butters and making a more educated buy that way. Interesting that you made a similar point.

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