Stock Options Trading Idea of the Week
Reduce Risk by Selecting Different ETFs for Your Underlyings.
This week we will discuss using a butterfly spread as an option strategy tool. Buying a butterfly spread as a single purchase is a risky proposition (because if the stock moves more than moderately in either direction, you can lose your entire investment). However, as part of portfolio of calendar spreads, it can be used to protect against loss if the stock should move strongly in a certain direction.
Terry
Reduce Risk by Selecting Different ETFs for Your Underlyings.At Terry's Tips, we have been researching the possibility of using butterfly spreads to provide downside protection for our 10K Strategy. As you may recall, the 10K Strategy uses calendar spreads at several different strike prices and depends on premium decay to generate gains most every month.
This strategy has made exceptional gains when the market is stable or fluctuates moderately either up or down, but has experienced losses when a large drop occurs.
A butterfly spread is added to the calendar spreads to provide downside protection in case the stock moves more than moderately during the expiration month. In order to provide this protection, the strike prices of the butterfly would have to be lower than the current stock price.
Brief Description of a Butterfly Spread (One we Placed About a Year Ago :
At the time, SPY was selling about $135 a share and we wanted to add some protection in case it fell as far as $125. The spread we placed was this one:
Long 10 Aug08 130 puts
Short 20 Aug08 125 puts
Long 10 Aug08 120 puts
Total cost of this butterfly spread = $1.10 ($1100 for 10 spreads)
This is the risk profile graph for these positions:
The butterfly spread gets its name because a graph of its returns are supposed to look like a butterfly, but it never looked that way to me.
The maximum gain for a butterfly spread comes when the stock ends up exactly at the strike of the short options. If it lands there, a very large gain results (in this case, over 4 times the cost of the spread). There are some interesting aspects of butterfly spreads:
- The initial cost is your maximum loss.
- If the stock ends up above the highest strike or below the lowest strike, a total loss results.
- The closer the mid-point (the short option strike) is to the stock price when it is bought, the more expensive it is (if the above butterfly were bought with all the strikes 5 points lower, the spread would cost $.53 instead of $1.10).
Since we would like to use a butterfly spread to provide protection on the downside, we would select a mid-point at a strike much lower than the current price of the stock. If the stock falls more than moderately so that the mid-point strike is approached, a large gain could occur which would offset the loss on the calendar spreads from the falling stock price.
If we added a butterfly whose mid-point was 10 points lower than the original stock price, it would only cost $.50 or so (this compares to the $3.00 or so in premium decay we would be collecting from the at-the-money options we have sold in the calendar spreads). Conceptually, we would be giving up some of our potential decay gain to provide excellent protection in case the stock were to fall by a large amount.
Most investors use calls when placing butterfly spreads rather than puts. However, the risk profile is identical regardless of whether puts or calls are used. Usually they are placed with the short strikes close to the current market price so that the maximum gains come when the market is flat (if the investor believes the market is headed higher, he or she would place the spread at higher strikes).
Next week, we will discuss permutations that can be used on the typical butterfly spread that provides downside protection over a much larger range.
Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
You can see every trade made in 7 actual option portfolios conducted at Terry's Tips and learn all about the wonderful world of options by subscribing here. Why wait any longer to make this important investment in yourself?
I look forward to having you on board, and to prospering with you.
Terry
Andy's Market Report
It was another slow week for the market. Economic and corporate news was essentially nonexistent this past week and should be again during the holiday shortened week next week. The S&P 500 (SPY), Dow (DIA), Nasdaq 100 (QQQQ) and Russell (IWM) declined 1.2%, 1.1%, 0.5% and 1.6%, respectively. However, for the year, the S&P 500 is up 12.5%, the Dow has advanced 7.6% and the Nasdaq is leading the way with a 28.0% gain.As for the technical picture, Tuesday's sharp decline closed the gap from 8/21 and has left the major indexes back in a neutral state. Even though the market finished lower for the week, it was certainly a positive to see the market respond so favorably after the gap closed. This is the second over the past four weeks that we have witnessed a gap close and the market respond favorably immediately afterwards. Indeed, a positive sign going forward.
As for economic news, as I stated before, it was few and far between. However, there were a few keys reports that should have market participants somewhat happy.
The Chicago PMI and ISM Manufacturing Index both reported an expansion in manufacturing and the ISM officially moved back into expansion stage after reporting a better-than-anticipated reading of 52.9.
"While some of the rise in today's headline number was probably related to the auto sector, the improvement was much broader than that," Michael Feroli, an economist at J.P. Morgan Chase, told the Washington Post. Overall, the ISM report represents "a strong signal that industrial output will contribute significantly to overall economic growth in the second half of the year," according to Feroli.
The Pending Home Sales report also pleased Wall Street with its sixth consecutive month of positive readings. The report showed a 3.2% rise in July.
The big economic report of the week came Friday with the Unemployment report. The unemployment rate surged to 9.7% after it was reported that the economy lost another 216,000 in August. The reading means that more and more Americans will have to endure economic hardship for months to come, which will most likely delay a full economic recovery.
"In the context of a full-blooded recovery, this report is disappointing," said Alan Ruskin, an economist with the Royal Bank of Scotland in Stamford, Conn. "We're still clawing our way back."
"It's a good picture compared to where we were, which was just a free fall," said Dean Baker, a director of the Center for Economic and Policy Research in Washington. "But compared to anything else, this is just a horrible report. The rate of decline is slowing, but it's not going to stop. We're likely on a path toward more than 10 percent unemployment."
Again, next week is a slow one on the economic front, but there are a few glimpses of market-moving potential. The Fed Beige Book is out on Wednesday and Initial Claims Thursday. Could we see another surge higher over the coming weeks? It certainly does not look out of the question.
Overbought/Sold Condition Report
Overbought/Oversold as of September 8, 2009Major Benchmarks- S&P 500 (SPY) - 57.5 (neutral)
- Dow Jones (DIA) - 55.8 (neutral)
- Russell 2000 (IWM) - 53.5 (neutral)
- NASDAQ 100 (QQQQ) - 65.7 (neutral)