Fly Your Way Into Double-Leveraged Short Side Profits

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 |  Includes: SDS, SPY, SSO
by: Richard Bloch

I wrote an article on May 1 looking at the difference between using options on two different, yet opposite, double-leveraged ETFs to take a short position in the market. Should you buy puts on the double-leveraged Ultra S&P 500 fund (NYSEARCA:SSO) or calls on the double-leveraged UltraShort S&P 500 fund (NYSEARCA:SDS)?

The good news? The trade I mentioned is going "my way."

The bad news? I didn't buy the spreads I suggested as I was merely looking at which options - SSO or SDS - would work best.

The pretty good news? In the short-run, it didn't matter much whether you bought call spreads on SDS or put spreads on SSO, which is the conclusion I drew in my article.

Here's an updated theoretical profit and loss chart showing how each spread would have performed.

The bottom axis on the chart is based on the return of the S&P 500 ETF (NYSEARCA:SPY). The grey arrows show the approximate position profit as of the May 4 close.

So far, the SDS spread would return a net profit of $1120 on a $1000 investment, while the SSO spread would return a net profit of $1110 on a $990 investment. Each represents a return of about 100%.

But what would you do now if you had actually placed the trade?

If you thought the market would bounce around for awhile, you might consider converting the trade into a butterfly spread. In fact, anytime you're long a call or put spread, you can think about using a strategy like this.

Butterfly spreads: Profiting from little to no movement.

Normally, I'm not a fan of butterfly spreads. That's when you're long one option at a low strike price, long one option at a higher strike price, and short two options at a middle strike price.

Take SSO as an example. It closed on Friday at $55.11. Let's say you think it will hang out near 55 for a couple of weeks. You might sell 10 May 55 puts, which are at the money. Then you'd buy puts on either side, perhaps buying 5 of the May 53 puts, and 5 of the May 57 puts.

Your total net debit would be $255 with a payout structure that looks like this at expiration:

If you're good at picking a spot where a stock or fund might drift for awhile, you can make some pretty good money. But if it moves up or down a lot, you'll lose money. That risk is limited, of course, but it's exceedingly challenging to pick that one sweet spot of maximum profitability.

A guaranteed profit

But what if you could fly your way into a butterfly spread with a guaranteed profit? Well that's a different story. And if you owned, for example, that put spread on SSO you could convert it into a butterfly spread.

Here's how: Let's say you'd established that long 10 May SSO 58 put and short 10 May 54 put trade back on May 1 for a net debit of $990.

Now you could make an adjustment. Here's an example:

  • Original position
    Long 10 May SSO 58 puts
    Short 10 May SSO 54 puts
    Original net debit: $990
    Sell to close 5 May SSO 58 puts for a credit of $1575
    Buy to open 5 May SSO 50 puts for a debit of $140
    New net credit: $445

You started out being long 10 May 58 puts and short 10 May 54 puts.

You're not touching your short 10 May 54 put position, but you're selling 5 of your profitable May 58 puts and completing the butterfly by buying 5 of the May 50 puts. So now you've got a 50/54/58 butterfly spread in a 5/10/5 configuration.

And as the payout structure shows, you can't lose.

Yes, I know SSO could have some tracking error, but not likely much in the next couple of weeks. And it's possible that volatility could grow higher.

If SSO does maintain a steady level, you could make a lot more than $445, but at least you've locked in a gain on either side of the short strike at the 55 level.

Ouch! You broke my wing!

You could also adjust your spread based on some bias you might have on what will happen to market between now and the May 19 expiration, For example, if you have bearish bias, you could do something like this:

  • Original position
    Long 10 May SSO 58 puts
    Short 10 May SSO 54 puts
    Original net debit: $990
    Sell to close 10 May SSO 58 puts for a credit of $3150
    Buy to open 5 May 57 puts for a debit of $1275
    Buy to open 5 May 52 puts for a debit of $270
    New net credit: $615

Once again, you're not touching your short 10 May 54 put position. But there's more distance between the strikes on the upside than the downside. The profit and loss on this trade looks like this:

This is called a "broken wing butterfly" because it's not symmetrical. That $615 credit you've collected is yours if SSO moves up. You'd make a lot of money near the short 54 strike, but if it fell further, you'd make more than $1000 at any expiration price.

If your bias is bullish, you might do this:

  • Original position
    Long 10 May SSO 58 puts
    Short 10 May SSO 54 puts
    Original net debit: $990
    Sell to close 5 May SSO 58 puts for a credit of $1575
    Buy to close 10 May SSO 54 puts for a debit of $1050
    Sell to open 10 May SSO 55 puts for a credit of $1400
    Buy to open 5 May 51 puts for a debit of $195
    New net credit: $740

Here you're replacing your short 10 May 54 puts with 10 of the May 55 puts. And you've adjusted the distance between the strikes to favor the upside.

Now you've got a guaranteed profit, but it's a lot less if the market falls than if it rises. You'd keep the $740 credit is SSO were above 58, but only $240 if fell below 51.

So anytime you put on a bull call spread or bear put spread, think about adjusting into a butterfly spread if it starts generating significant profits. You can always just close your position, but adjusting it for a guaranteed credit - regardless of what happens - is definitely worth considering.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.