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Old 01-03-2002, 05:42 PM
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Default skewed AND capped: the commission machine!



Having never worked as a commodities broker, I had never before recognized the true beauty of what is known as the "butterfly spread." But, prompted by such a blatant sucker's confession, I think maybe it is appropriate to warn people.


Since a commodity broker cannot actually hope to make his client a winner, what he will generally try to do is 1) to try to make his client win more often than he loses - by introducing a skewed strategy - so that the client feels like he is winning, but also 2) to try to ensure that when the client does lose, he loses slowly.


In other words, the broker would prefer you to lose your money in the form of commissions, rather than to the market - losing a small amount on a large number of trades over a long period, and never too much more than your paycheck. But another interesting aspect of the futures market is that once the client has lost his inheritance and his kids' shoes, the additional losses come out of the broker's pocket. So the broker can never sleep when his suckers' losses on a given trade aren't "capped."


The first thing a commodities client "learns" is that, if you can hold on long enough and keep posting margin, the market always seems to come back to where it will show you a tiny profit, and you can get out. Moreover, when the client buys calls or puts and becomes a paper millioanire, he always seems to fail to exit at the right time, and it never amounts to anything.


So, at heart, the client is a counter-trend trader. When the market rises, he is inclined to sell, and when the market falls, he is inclined to buy. Therefore, the seemingly perfect strategy to satisfy the client's needs 1) to win more often than he loses, and 2) to trade against the trend, is to sell calls when the market is rising and is volatile, or to sell puts when it has gone "too low." He can get away with this many times in a row.


But the problem with the naked call strategy is the broker can't sleep at night. When the client finally blows out, chances are it will sweep away the broker's account too. So the next logical modification to the naked call-writing strategy is the "bear spread" - whereby the customer writes a call, and takes in an immediate credit, and then buys a higher call for a lower price, to protect him from an infinite loss in the call he sold.


The bear spread is better than the naked call - the client wins over a larger section of the normal distribution than where he loses, and his losses are capped to the difference between the two strikes - but it is still not perfect. By adding a "bull spread" to the bear spread to make it into a "butterfly spread" - by selling two calls at the lower price instead of one, and then buying a fourth call at an even lower price to hedge the second one sold, you reach perfection.


Using the butterfly spread, you create a situation where 1) the broker is guaranteed that almost nothing really happens, apart form the client paying a commission, and 2) the client is compeletely entranced by the ins and outs of how he is sneaking an edge or trick in there somewhere, for sure!


I have spent a lot of time around commodity offices, and I always wondered why they kept those full-color option-strategy posters around the office, and wasted their time explaining them to total idiots off the street but never gave the same courtesy to me. And I remember another time the joke of the week around the office was the line, "That sounds like a profit situation!," spoken in a stupid southern accent - mimicking a a new client. Now it all makes sense!


Anyway, don't kid yourself with the butterfly spread - or any other over-simplified options nonsense.


eLROY
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Old 01-04-2002, 04:19 AM
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Default I use the butterfly spread to dodge tax



transferring capital from the current taxable to a non-taxablw market as yet, getting more cash to compound + less tax payable. Outweighs the brokerage fees.
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