Stocks are barely moving today, despite it being busy earnings and IPO week. The market is sitting at all-time highs… will it break out further to the upside or is this where it will come up against resistance and sell back down?
I’m watching the VIX, what the Fed is saying, and other market internals for clues. I trade options, so I really have no limits on how to trade the market.
For example, I can use strategies that make money when volatility is exploding or collapsing… when stocks are trending or choppy…
And until further notice, stocks appear to be stuck here… a slow grind higher… waiting for the next catalyst. That said, specific strategies are working well in this market, and should continue to do so if stocks stay range-bound.
For example, Nathan Bear, probably had the trade of the year, trading an options strategy called the butterfly. It is somewhat advanced, and perhaps not the first strategy you should apply when you first get started with options.
However, I’ll try my best to breakdown, so it’s not too overwhelming. Furthermore, the risk vs. reward on this strategy is so good… you’ll want to add it to your options arsenal.
For example, Nathan’s butterfly had returned as much as 500-600%…
But to be fair, he started peeling off profits at a measly 300%
(If you want to receive real-time alerts by me, as well as Nathan Bear, here’s your chance)
As I mentioned, the risk vs. reward on trades like this can’t be beaten… Furthermore, I put together a quick lesson for you to help understand the strategy further.
The butterfly strategy is another tool to keep in your kit when you’re trading options. Now, the butterfly strategy could be constructed either using both calls or puts, but we’ll be focused on using them with call options today.
Before we break down the strategy, let’s get an idea of how a butterfly works and when you want to use the strategy.
Here’s a look at how the profit and loss (PnL) of the strategy would look on the expiration date of the options.
If you can tell from this, you would want the stock to trade in a tight range, and your profit point is reached when it reaches a certain price.
That in mind, traders use this strategy when they anticipate low volatility in a stock within a specified period.
Now, let’s get into how you would construct this strategy.
The setup involves:
- Buying a call option at strike price A
- Selling two call options at strike price B
- Buying a call option at strike price C.
Ideally, you want the stock to be around strike price B. Now as you can see, your maximum profit would occur when the stock price is just below strike price B. The maximum profit potential is simply strike price B minus strike price A minus the net debit paid.
Additionally, your maximum loss is limited to the amount you paid to open the position.
Now, it may be confusing for you at first… but let’s break this down further.
Breaking Down the Butterfly Strategy
I find it helps to think about this as two components – two strategies that make up the butterfly. Rather than thinking of the trade as buying a call option with a strike price below where the stock is trading… selling two call options at a strike price right around the current strike price… and buying a call option at a strike price higher than the current price… think of it as just two trades.
What am I talking about here?
Well, if you think about it the butterfly strategy (using call options) is just a long call spread and a short call spread.
Now, let’s get a refresher on how the long call spread works.
The long call spread involves buy calls and selling calls. Here’s a look at the profit and loss (PnL) diagram of the long call spread on the expiration date.
Basically, you want to buy a call with a strike price at or below where the stock is currently trading… while selling a call option with a strike price above the current stock price.
For example, let’s say a stock is trading at $50. Well, to open a long call spread, you would buy a call option at say $49, and sell a call option at $53. This means that you’re bullish but have an upside target.
Now, the other component of the butterfly strategy is the short call spread. Here’s a look at the profit and loss chart at expiration.
With this trade, you would sell a call at strike price A, buy a call option at strike price B. Now, generally, the stock would be below strike A.
Look closely at the PnL charts of the short call spread and the long call spread. When you combine the two, it starts to look like the butterfly strategy right?
However, the long call and short call spreads converge at a strike price B.
Combining Long Call and Short Call Spreads
For example, let’s say you think Apple (AAPL) will trade in a range around $205. Here’s a look at how the first component (the long call spread) would look.
With the long call spread, we’re selling 1 option contract with a strike price of $205, and buying a call option with a strike price of $195.
On the other hand, you have the short call spread.
With the short call spread, we’re selling 1 call option with a strike price of $205, while buying 1 call option with a strike price of $215.
Remember, the short call options converge at $205 (an area where we think AAPL) would trade around.
Now, what happens when you combine the two?
You’ll see a risk profile (PnL at expiration) like this:
Pretty simple when you break it down, right?
Well, if you’re interested in learning more options trading strategies or just need a refresher… check out my eBook – 30 Days to Option Trading.