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Guest Post: Learn How Out-of-the-Money Butterflies Create Profits Trading SPX
Submitted by Options Trading Signals
Learn How Out-of-the-Money Butterflies Create Profits Trading SPX
Over the past few weeks the broad stock market has seemingly grown
increasingly more bullish. Market pundits, traders, and even high
profile money managers are stating publicly that the easy trade over the
next few years will simply be being long high quality stocks. While
time may prove these managers wise, it is likely a bit early to be that
bullish.
As a trader, our job is to create profits consistently regardless of
price action. The best traders are masters of blocking out the noise and
emotion, and letting various forms of data guide their decision making.
At this point in time the bulls have the bears pushed against key
resistance at the SPX 1150 area. However, the bears have their eyes set
on the 1130 level and from there the key SPX 1040 support area.
If the S&P 500 breaks out over the 1150 area with strong volume
we could move higher to test recent highs; however, if the 1040 area
were to give way to the bears the bullish parade would end. At this
point in time, it is too early to tell which side is going to win this
battle. The monthly chart of SPX tells the entire story.
Until proven otherwise, my bias is to the downside. What might
surprise most readers is the reasoning behind my thinking. My
expectation of lower prices has nothing to do with macro economic
conditions, it has nothing to do with unprecedented intervention that we
have witnessed by the United States federal government, and it has
nothing to do with housing numbers. The reasoning behind potentially
lower prices is simple, defined risk. The SPX chart above and even the
daily chart listed below are both indicative that the SPX 1150 area is a
critical psychological level for market participants. We are literally
at a precipice right here, right now.
When major resistance or support is very near the current spot price
of any underlying, typically low risk/reward setups can be found. After
spinning through several ideas and option strategies, an out of the
money butterfly spread seemingly made a lot of sense. The out of the
money butterfly spread would benefit from the passage of time and would
not be as exposed to a comeuppance in volatility. This strategy could
produce a great potential return for a defined amount of risk.
After some brief analysis, the best proxy was using the Spider ETF
SPY as opposed to the SPX index. The bid/ask spreads are quite wide on
SPX at times, particularly when volatility is rising. Consequently, it
can be arduous to get decent fills from the SPX market makers in rapidly
moving market conditions which seem to be the norm recently. Besides
the normal option expiration on monthly or quarterly basis, options that
expire every week have grown in popularity recently. A primary reason
why volumes have exploded is due to the weekly expirations routine
offering of unbelievable risk/reward setups, particularly through the
utilization of Theta (time) decay trading setups.
After running through various expiration dates, it made since to
utilize the October weekly options that expire on Friday, October 8.
Since I have a bias to the downside, I used an out of the money put
butterfly. Traditional butterflies are typically written where the
current price is straddled by the wings of the butterfly spread. In an
out of the money butterfly, an option trader places the entire position
out of the money. It helps reduce the cost of the butterfly, and because
the option contracts are out of the money, they are not impacted as
harshly by rising volatility. In addition, these out of the money
butterflies usually have very attractive risk/reward characteristics.
SPY was trading around $114.13/share at the close on Thursday, so the
out of the money butterfly I constructed had the following strikes:
Long 1 OCT WKLY. SPY 108 Put / Short 2 OCT WKLY. SPY 111 Puts / Long 1
OCT WKLY. SPY 114 Put. Here is a snapshot of the SPY October weekly
option chain as of the close Thursday:
The Thursday closing option prices are as follows for the butterfly
mentioned above: SPY 108 Put = $18/contract; SPY 111 Put = $37/contract;
SPY 114 Put = $127/contract. The total cost to place the out of the
money SPY weekly put butterfly would have been $71 per side (not
including commissions). The maximum gain at expiration on this trade
would be a close at $111/share on SPY and it would produce a profit
around $225 (not including commission).
Clearly we would not expect to achieve the maximum gain, but this
trade would produce a profit if SPY closed between $108.70/share and
$113.30/share at expiration (October 8). The profitability chart is
below; keep in mind that the red line is the valuation at expiration and
the white line would be the profit based on that particular day.
Obviously market conditions throughout the trading day Friday and
next week will alter the prices and implied volatility of this trade.
This should not be viewed as a trade that should be taken, but an
example of what kind of returns are possible for option traders that
want to use out of the butterflies with a directional bias.
The most exciting thing about a trade like this is that the trader
can crisply define his/her risk. When the maximum risk is a specified
amount, managing risk becomes almost arbitrary. A trader simply
determines how much he/she is willing to risk/lose, and simply places
the trade. A mere $142 risk could produce a potential profit well over
$450! Keep in mind, that should price move within the confines of the
outer strikes (wings) of the butterfly, it might make sense to take
profits depending on the size of a trader’s position. Typically I like
to take profits once price action has produced a gain of 10-20%
depending on market conditions, time frame, and the strategy that I am
using. After taking profits, I typically utilize contingent stop orders
for the remainder of my position and manage it accordingly.
There are additional manipulations that could be made if price looked
like it were going to break below the 108 strike level that would allow
this trade to either remain essentially flat or potentially profit even
more. Additionally, a similar trade using calls could be placed using
the weekly call strikes 115/118/121 for a trader who was bullish.
Regardless of a trader’s directional bias, the beauty of options is not
only their ability to produce setups where risk is clearly defined, but
the potential to manipulate a position in real time allows for
fluctuations in price action or market conditions.
As for the direction of the market, who knows what the next six
trading sessions will bring. Sometimes not trading is the best trade,
but if you absolutely feel you must have some exposure, keep positions
small, risk exposure tight, and do not hesitate to take profits – easier
trades lie ahead.
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Titanium Pterodactyl Bitchezzz [NO-you CANNOT steal it] :P
you = gay
Wtf @ your junks? Since when did this become a left wing jon stewart-run site for hippies?
Look out below Bitchez!
Following is a table of the total amount bought and sold in companies in the Standard & Poor's 500 Index during the week ending Oct. 1 broken down by industry.
The figures are compiled from Securities and Exchange Commission filings by Washington Service.
http://www.bloomberg.com/news/2010-10-04/weekly-insider-buying-and-selli...
Total Insider Total Insider Purchases($) Sales($) ============================================================================= Consumer Discretionary 49,904 59,580,319 Consumer Staples 0 42,873,713 Energy 0 22,485,400 Financials 0 5,484,705 Health Care 0 9,048,016 Industrials 127,160 5,114,466 Information Technology 0 260,145,994 Materials 0 856,118 Telecommunication Services 0 0 Utilities 0 8,387,970 ----------------------------------------------------------------------------- Total 177,064 413,976,700you = gay
OK, that's getting a little old now.
good stuff, Spalding. cheers for that.
Do these tallies account for sales as a result of incentive stock/options? I've been wondering for a while...
If they don't the sales would always be higher right?
Pull yourself together. Don't throw a tantalum.
Let me ask a question.
What if stocks go up 5% but commodities go up 25%?
I am so sick about this fuckin' argument about the cost of capital being so low. Who gives a shit if there is no demand among credit worthy borrowers? Who here is lending to the 12% of Americans on food stamps? No one. What about the credit worthy borrowers that don't want to borrow b.c their business is in the shitter? So Bernanke buys all the cotton in the world to print these fuckin' dollars, my wealth is better preserved buying cotton, probably why the cost of cotton has shot through the moon.
Jim Rogers is right. If the economy sucks the FED will print money which will benefit commodities over stocks, and if the economy recovers than we will need commodities. Where is your wealth better protected? Yea...I'm talkin' my book and my book makes sense.
It will be interesting to see if Benny and the Jets (POMO Pimps) can gun this overbought S&P higher tomorrow.
How about just shorting the damn thing. For the unintended consequences of an overly complex trading strategy, see "MERS".
Why not keep it simple, just buy 114 put and sell 111 put, for $90. Max profit is almost as good, $210, and no worry about a drop below 111 or 108?
Good point. Butterflies are transaction cost heavy and work best with low volatility and plenty of patience. Good luck on that in this market.
Major companies have been sandbagging guidance, when earnings roll out the next few weeks, they will be "less bad" than expected and stocks could rally again.
Hard to believe they are pulling the same trick as they did in 2009, but when CFO's were blasting guidance the last two quarters nobody thought about the possibility that they were getting the worst out of the way so that next quarter things would not look so bad.
That's why everyone is piling into bonds because it's October and everybody is bracing for the worst in earnings.
Interesting perspective Robo.....where did you pick up the sandbag info?
I don't think they can sandbag this one. Were priced too high. You got companies that have to hit it out of the park and guide higher to gain ground, even if they have blow out earnings but hazy outlook you'll get a cisco takedown or adobe.
The four horsemen of NASDAQ I'm watching here. We all know apple will crush everything, but will it gain or sell off?
I don't expect fins to have juice this quarter, without them we aint breaking thru the April highs. I'm expecting bad disappointments for the whole sector.
AAPL went limp and it's about to fall over.
They're harder comps to go by and we had a strong surge.
July earnings season roared higher on week monthly start and comps were exaggerated over last years.
Input costs are gonna squeeze with commodity prices rising and not being able to pass on costs.
Also trace the inverse dollar fall over sept. To collerate with the index gains.
The USD is sprouting a little green shoot today. If by chance it just happens to be one of "Jack's beans" then all bets are off.
I agree with the others and their vertical spreads. I have never been able to talk myself into a butterfly because of the commissions. It seems the strategy described here works best for the brokerage house, unless someone in ZH land knows how to buy butterflies on the cheap.
"because of the commissions. " ?
butterfly.
three separate options.
$5/option. $15 commission.
trading 10 contracts each.
This isn't "technical analysis", per se. Rather this type of analysis should be referred to as "Equivocation Analysis".
Options Trading Signals writes:
"If the S&P 500 breaks out over the 1150 area with strong volume we could move higher to test recent highs..."
Really? It "could"?
"The SPX chart above and even the daily chart listed below are both indicative that the SPX 1150 area is a critical psychological level for market participants."
A "critical psychological level"...
Anyone who buys into this tripe is at a critical psychological level.
It may be small numbers compared to the overall economy, but there are now 90,000 unemployed each week who exhaust all unemployment benefits. How can you lose the buying power of unemployment for 360,000 people each month and increase profits in retail, etc? I ask, since I'm dumbfounded as to how the growing ranks of unemployed (3-5 million) who are no longer able to collect unemployment benefits are ignored by the markets?
WTF does any of this matter?
We have no volume whatsofreakinever, insiders bailing by the droves, nonstop retail outflows, implied correlations near 1. Ok, where exactly ARE the "money managers" who are buying stocks, where are the "bulls and the bears"? Bc all I see is bullSHIT.
Im thinking the big money is still undecided. Vol is shit, but hey, lets get us above that R point and let the machines do the rest.
How much of a factor is a weaker dollar in driving up the market?
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