In one of my previous articles, I described a possible trade for sideways markets. The trade used a strategy called an Iron Condor. The Iron Condor is a combination of a bull put spread and a bear call spread.
In this article, I would like to present another strategy which can be used if the trader has a neutral outlook for the specific stock or ETF. The strategy is called a Butterfly. It is very similar in structure to the Condor strategy, but the two options located in the center of the pattern have the same strike prices.
A Butterfly strategy is a limited risk, limited reward, non-directional strategy that is designed to make profits if the stock remains in a limited range. It can be structured with calls only, puts only or the mix of both. It is best used for index ETFs like SPDR SP&P 500 (SPY) or iShares Russell 2000 Index (IWM). Some ranged bounded individual stocks like Microsoft (MSFT), Johnson & Johnson (JNJ), General Electric (GE) or American Express (AXP) can also be good candidates.
Let’s use the SPDR SP&P 500 (SPY) as an example:
- Buy 10 SPY Jan. 2012 120 calls
- Sell 20 SPY Jan. 2012 125 calls
- Buy 10 SPY Jan. 2012 130 calls
With SPY currently trading at $125.60, the trade can be done for $0.94. Ten contracts will cost $940. The maximum profit is $4,060 or 322%. It is realized if SPY is exactly at $125 at January expiration. The reason for such high potential profit is that At The Money options have the highest time premium and we are selling 2 of those options. But don’t be fooled by the high potential profit. The probability to make anything close to this is very low. The goal here is to hold for a couple of weeks and book profits quickly if SPY stays inside our range. Don’t be greedy as even a single day’s large move can erase all the gains.
How do we make money from this trade? The trade is theta positive and vega negative. Assuming that SPY doesn’t move a lot, we make money from the time decay as well as Implied Volatility drop.
So if you think that S&P 500 goes nowhere in a near future, it is a good time now to place a butterfly trade.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.