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One of my favorite options strategies is the 'long put butterfly' spread. I will consistently use this strategy on range-bound stocks and ETFs, such as the Power Shares Trust (QQQ), Cisco (CSCO), Intel (INTC), Johnson & Johnson (JNJ), Walmart (WMT), and Microsoft (MSFT).

The key to this strategy is choosing a stock or ETF that has weekly options available and does not see large price swings during the week. For a list of weekly options available, please see this link.

The 'long put butterfly' spread is a debit spread, unlike the more often used 'butterfly spread,' which is a credit spread that has an options requirement.

One of the biggest mistakes traders make when using this strategy is using it with volatile stocks. For example, securities with large daily and weekly price ranges are a bad choice with this strategy. Molycorp (MCP), Priceline.com (PCLN), Netflix (NFLX), Google (GOOG), CF Industries (CF), Direxion Financial Bull 3X (FAS), Direxion Financial Bear 3X (FAZ), SPDR Gold Trust (GLD), and other similar stocks or ETFs fit this criteria.

This strategy should be placed preferably on a Monday or later when the options expire on a Friday. Time-value is not necessarily a good thing with this strategy. The less time that the stock or ETF has to make a large price move, the better.

Buying forward month options with this strategy can present a boatload of problems, and I highly discourage doing so. Another way to profit using this strategy is right after a company reports earnings (when the news is already baked into the stock). Naturally, you will want to wait until the market digested the earnings numbers so there are no surprises.

The 'long put butterfly' spread has three (3) "legs" to place: (Note: I am using only the minimal amount of contracts to describe how it is accurately placed).

Long Put Butterfly Construction

  • Buy 1 OTM Put
  • Sell 2 ATM Puts
  • Buy 1 ITM Put

Now, I would like to show a few trades with this strategy using the stocks and ETFs mentioned earlier. As I write this article, it is Tuesday afternoon, and this is how I would make these trades.

I will start with a Power Shares Trust trade, and here is how my trade ticket would look if it was trading at $62.91.

  • Buy 10 QQQ February 2012 $61.00 put options
  • Sell 20 QQQ February 2012 $63.00 put options
  • Buy 10 QQQ February 2012 $65.00 put options

Requirements

Cost/Proceeds $1,280.00
Option Requirement $0.00
Total Requirements $1,280.00
Estimated Commission $50.00


Here is a closer look at the profit/loss chart:

Current Price: $62.91

Price Profit / Loss ROI %
45.75 ($1,280.00) -100.00%
52.56 ($1,280.00) -100.00%
59.73 ($1,280.00) -100.00%
61.00 ($1,280.00) -100.00%
62.28 $0.00 0.00%
63.00 $720.00 56.25%
63.72 $0.00 0.00%
65.00 ($1,280.00) -100.00%
66.91 ($1,280.00) -100.00%
74.08 ($1,280.00) -100.00%
81.25 ($1,280.00) -100.00%

What I really like about this strategy is that there is a window where the stock or ETF can move up or down a decent amount (for a high volume security) and you will still profit. This specific trade with the QQQ has a great chance at making a very good profit.

It is extremely important to note that each week you make this type of trade the strike prices must line up. This means that you should always make sure that the trade is as neutral as possible. Sometimes this is just not going to happen. When this occurs, move on to another trade. You do not want to be one-sided and directionally biased too much. There are plenty of other securities that make more sense.

For example, this week, I was looking at a Johnson & Johnson trade. After using my trade calculator to figure out where the stock needed to be in order for me to profit, I decided to stay away from it this week. Let me show you why...

I intended to use the following strikes, with Johnson & Johnson trading at $64.50/share:

  • Buy 10 JNJ February 2012 $62.50 put options
  • Sell 20 JNJ February 2012 $65.00 put options
  • Buy 10 JNJ February 2012 $67.50 put options

Requirements

Cost/Proceeds $1,960.00
Option Requirement $0.00
Total Requirements $1,960.00
Estimated Commission $50.00

Here is a look at the profit/loss chart:

Current Price: $64.61

Price Profit / Loss ROI %
46.88 ($1,960.00) -100.00%
54.07 ($1,960.00) -100.00%
61.65 ($1,960.00) -100.00%
62.50 ($1,960.00) -100.00%
64.46 $0.00 0.00%
65.00 $540.00 27.55%
65.54 $0.00 0.00%
67.50 ($1,960.00) -100.00%
69.22 ($1,960.00) -100.00%
76.80 ($1,960.00) -100.00%
84.38 ($1,960.00) -100.00%

With Johnson & Johnson trading at $64.61/share, the trade looks good on the upside, as it needs to make a rather large move for a stock that historically does not move too much. However, the problem is on the downside. There is a small window, only $0.15, that will put you in the negative if the stock should move down. This is a bad trade. It is uneven and directionally biased. There will be other weeks when aligning the strike prices that Johnson & Johnson makes perfect sense. This is not one of them.

Here is a Microsoft trade that can be placed on a Thursday. Microsoft is trading at $30.05/share at the time of writing.

  • Buy 10 MSFT February 2012 $29.00 put options
  • Sell 20 MSFT February 2012 $30.00 put options
  • Buy 10 MSFT February 2012 $31.00 put options

Requirements

Cost/Proceeds $630.00
Option Requirement $0.00
Total Requirements $630.00
Estimated Commission $50.00


Current Price: $30.05

Price Profit / Loss ROI %
21.75 ($630.00) -100.00%
25.01 ($630.00) -100.00%
28.45 ($630.00) -100.00%
29.00 ($630.00) -100.00%
29.63 $0.00 0.00%
30.00 $370.00 58.73%
30.37 $0.00 0.00%
31.00 ($630.00) -100.00%
31.88 ($630.00) -100.00%
35.32 ($630.00) -100.00%
38.75 ($630.00) -100.00%


When a stock has low volatility and reports earnings during the week at some point, one trade I like to enter is right after the news has been digested. Since a general direction has been established as to where the stock moved, this will take out a lot of the uncertainty as to a weekly direction. This is sometimes an ideal situation to place this trade. The important thing to remember is that you do not want to place this strategy with stocks with high betas or high implied volatility.

I currently use a weekly strategy with the SPDR Gold Trust that is very consistent. It uses a 'reverse iron condor' spread. You can read that article on Seeking Alpha.

If you ever have any questions about this strategy, please leave a comment or e-mail me. I will try to respond quickly. Thank you.

Source: Generating Weekly Income By Trading These Select Stocks And ETFs