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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ME PREDICT 3000% INCREASE IN USE OF LESBIAN NINJA VAMPIRES IN COMMERCIAL ADVERTISING ONCE THIS HAPPEN.
THIS NOT SOMETHING ME COMPLAIN ABOUT.
Posted by: Fake Grimlock |
October 13, 2010 9:56 AMSeriously, I think you're on to something there. :)
Posted by: Marshall Kirkpatrick |
October 13, 2010 9:59 AMNot sure what your cause of concern is about, really. They've been selling their users' art for years. http://shop.deviantart.com/
Posted by: Joel Smith |
October 13, 2010 9:59 AMJoel, you don't think there's a significant difference between an art marketplace and a stock-photo pipeline? I do. Perhaps I'm wrong though. Thanks for your comment.
Posted by: Marshall Kirkpatrick |
October 13, 2010 10:10 AMI don't think so. If anything, I think DA is the most well-equipped community to launch something like this. They've the insanely creative talent to keep it juiced. They've been a strong, vibrant community for many years and know how to protect and inspire their users.
I have strong confidence in their ability to channel that democratic philosophy and stay true to the soul of the community.
Posted by: Joel Smith |
October 13, 2010 10:55 AMAnything that offers people "a more flavorful departure from traditional microstock imagery..." is fine by me.
Posted by: Peter |
October 14, 2010 8:55 AMHow much of a percentage is Deviant Art keeping for themselves?
Posted by: iCurious Media |
October 14, 2010 11:54 AM
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