Occasionally we have used a butterfly spread when we need protection in either direction because the underlying has moved more than our break-even range allows for during the month. A butterfly spread is an inexpensive way to buy more protection than you could get with a new calendar spread. For example, if SPY had fallen during the month while we had a downside break-even point at the $118 price, we would want to either add a new calendar spread at a strike below 118 or buy a butterfly spread with the highest strike at 118.
A typical butterfly spread for downside protection would be to buy 5 118 puts, sell 10 115 puts and buy 5 112 puts (all in the current month). With a week to go until expiration and the stock at $118, this spread would cost about $38, or $44 including commissions (there are 4 positions for each spread). For 5 spreads, the total cost would be about $220. If the stock fell to $116, the spread would be worth $1000 at expiration, so it would be excellent protection for a couple of dollars of possible stock price decline. The maximum gain from the butterfly spread would be $1280 ($1500 less $220 cost) if the stock ended up at exactly $115.
A calendar spread at the 116 or 117 strike (going out just one month to keep the cost as low as possible) would cost about $150 each. The butterfly spread would give far more downside protection per dollar of cost, but would expire worthless at any price above $118 (while the calendar spreads might show a gain if the stock did not move considerably higher than $118).
An exotic butterfly spread could be created by replacing the 118 puts in the above butterfly spread with 118 puts which had one or more extra months of life. It is sort of like buying a calendar spread at the 118 strike and a butterfly spread at the same time - the highest-strike leg of the butterfly spread ends up having extra month(s) of life.
In the exotic butterfly spread, the true cost of the most expensive leg (the highest-strike put, the 118 leg) works out to be the decay of the longer-term put which should always be less than the decay of the current-month put at that same strike.
The exotic butterfly spread costs a bit more than the calendar spread but yields more downside protection than the calendar spread. In the above example, it would cost about $180 per spread as opposed to the $150 cost for the calendar. If the stock fell to $116, the calendar spreads would end up making small gains but the exotic butterfly spread would make a significant gain. If the stock edges up a bit, the exotic butterfly might make a small gain while the conventional butterfly would be a complete loss.
When you need downside protection, the best way to figure out whether it is best to add calendar spreads at a lower strike or a downside butterfly, or a combination of the two (i.e., an exotic butterfly spread) is to use the Analyze Tab at thinkorswimand test the alternatives, picking the best-looking curve that you can create with the funds you have available.
In similar fashion to just about everything in options, the possible adjustments are complicated, and for every advantage one solution might have, there is always some sort of negative aspect that accompanies every possible solution. Playing what-if scenarios with the graphing software is the only way I know of picking the best alternative solution(s).
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Terry
Major stock indexes rose for the sixth straight week and seven out the last eight. The Dow briefly topped 11,000 for the first time in months and closed the trading session Friday at an eighteen month high.
"Round numbers are always psychologically significant," but rarely do they represent a technical milestone such as an index breaking out of a recent trading range, said Uri Landesman, head of global growth at ING Investment Management in New York.
The gains were driven by new signs that the economy continues to move in a positive direction towards recovery. However, many analysts' still remain skeptical that the recent gains that began in early March are sustainable since they have come on relatively low volume. The low volume recovery indicates that a large number of investors are still hesitant about the economy and the market in general so they have decided not too participate by sitting on the sidelines.
To my amazement, the bulls have continued to roll over every bearish set-up over the past month or so.
I am still sticking with a short to intermediate-term move to the downside over the next few weeks to months. The decline, if and when it happens, should move back down to the gap from 3/5. My feeling is that the S&P 500 has maxed out its gains over the short to intermediate-term and should push back, at least to the gap from 3/5. More specifically, a move to the $112.34 in the S&P 500 (SPY) or $45.76 in the NASDAQ 100 (QQQQ)
The probability of the move has further increased the recent historic extreme in the ISE Equity Put-Call Ratio, a very reliable indicator.
The reading has pushed to 276 at yesterday's close which makes it only the fourth such reading to move above the notable 275 mark. This means that traders purchased nearly three times more call options than put options.
It has been a month and a half since the S&P has lost more than 1% so it makes since that call buyers have become more and more speculative as time has passed.
There have been four other times when the ISE Equity Put-Call Ration has pushed above 275 and each time the S&P has declined dramatically over the next two weeks.
| 6-15-07 | S&P lost -1.9% |
| 7-12-07 | S&P lost -4.0% |
| 10-8-07 | S&P lost -3.2% |
| 10-28-07 | S&P lost - 6.6% |
As you can see it does not look too promising over the next two weeks for the major indices given the aforementioned. Couple this with a 'very overbought' market and short-term seasonal bearishness and Mr. Probability quickly swings towards the bearish camp.
Of course, as we all know there are no certainties in trading. However, as a trader, I thrive when the probability leans so far in one direction and now is one of those times. Again, there are no certainties, but probabilities are all we have as traders, right?
Andy
Overbought/Oversold as of April 12, 2010
Major Benchmarks