The Economics of Using a Longer-Term Option in a Butterfly Spread:

In our Mighty Stalagmite portfolio we might place a Sep-08 126-122-120 put butterfly spread to provide downside protection. A traditional butterfly would have all three options in the same month, but we often use a longer-term put for the highest strike leg of a put butterfly. (We would use the same policy for the lowest-strike option in a call butterfly.)

This means that instead of buying a Sep-08 126 put for $1.85 we could pay $4.85 for a Dec-08 126 put. We would have to spend $300 more for the spread than we could have by having all the options in the Sep-08 month.

In 35 days, the Dec-08 126 should decay by $.75 (assuming the stock stays flat). That means our "cost" of the 125 put is $110 less expensive ($1.85 - $.75) than if we had bought the Sep-08 126 put. We have to put up an extra $300 to save $110, so our investment in the longer-term put yields us 36% for the 5-week period.

That surely seems like a good investment even though it means we have less cash for buying calendar spreads. If we could make 36% on our money in every 5-week expiration month we would have no complaints.

On the other hand, at times, traditional out-of-the-money butterfly spreads are so inexpensive that they should be placed anyway (and the money saved used for generating decay with calendars). The choice between exotic and traditional butterfly spreads must be made on a case-by-case basis, and different answers may well result for different portfolios at different times.

Tune in next week for more Stock Options Trading tips.