I have to be honest.  When I read the headlines on the web these days I get this urge to climb out the window onto the ledge and then hurl myself to the ground below.  For the record my office is on the first floor so such an act would be more symbolic than dangerous.  Still the point is that the gloom and doom regarding the world economy is so thick it is hard to tell just exactly where the heck we are these days. 

This makes things extremely difficult for us “good little investors.”  As long as I can remember (and sadly it’s not as long as it used to be) the one thing that I have heard over and over again in this business is, “buy when fear is high.”  You may be more familiar with a variation of this phrase, such as “buy when there is blood in the streets”, “buy when everyone else is selling”, “buy when seven of your friends/relatives call you within a week asking you if you think they should sell” (this actually happened to me at the bottom in 2002), and so on and so forth.

So as a “good little investor” I can’t help but think that I should be buying like crazy right now and that a surprisingly strong move to the upside is just around the corner.  Still, as a(n occasionally) rational human being there is that voice in the back of my head that keeps saying “you know, if the Eurozone collapses into the abyss it could be a, ahem, slight negative for stocks.”  While I typically try to ignore the voices in my head, in this particular case, you’ve got to admit that they have a point.

Now for the typical stock market investor this situation can create a bit of a conundrum.  Do I buy and hope to profit – while staring in the meantime into the potential economic abyss?  Or do I remain on the sidelines earning 0.03% annual interest and risk getting left behind if something does happen to go right, thus triggering a market advance? 

This situation reminds me of the old Marine adage “advance or retreat, but don’t just stand there” (for the record, no I never served, but I do know a good adage when I hear one).  For an investor with money to invest (OK, there are still a few of them left) “advance” means buying stocks, “just standing there” means holding cash, and in all candor I’m not exactly sure what amounts to “retreat” except maybe selling any stocks you still hold.

In any event, this is a time when an option trading strategy can be extremely useful.

The Out-of-the-Money Butterfly Spread

As any good Optionetics student knows, a butterfly spread is an option trade that involves buying a call option at one strike price, selling two call options at a higher strike price and buying one more call option at an even higher strike price.  Entering this position affords a trader a “range of profit”, which simply means that the position will show a profit if the underlying stock stays within a certain range.  This week I want to show an example of a powerful variation of this basic strategy. 

The “classic” butterfly is entered into in a 1 by 2 by 1 ratio.  You sell the option closest to the current stock price, then buy a lower strike price and a higher strike price.  Then as long as the stock does not rise or fall too far a profit can accrue.  The strategy I want to detail this week is a tad more “aggressive.”  This position can be described as an “Explosive Out-of-the-money butterfly” (heretofore OTM Fly) and is constructed as follows:

Buy two call options at a strike price above the current stock price

Sell three call options at an even higher strike price

Buy two call options at a strike price higher than the one at which you sold

Now if you have no knowledge of options, by this point you are starting to wonder why you are still reading this so let me just say DO NOT STOP READING THIS (OK, subliminal messages have never been my strong suit). 

Whereas a “classic” butterfly is entered into in a 1x2x1 ratio selling the at-the-money option, the “Explosive” butterfly buys an extra call option.  As a result – and as you will see in a moment – it enjoys unlimited profit potential.

The best way to illustrate this concept is – as always – with an example.  So let’s consider the following position:

-Buy 2 June 2012 SPY call options @ 2.91

-Sell 3 June 2012 SPY call options @ 0.64

-Buy 2 June 2012 SPY call options @ 0.10

Using current option prices as this is written (the values could easily have changed for the better or worse by the time you read this), the total risk on this 2 by 3 by 2 position is $410.  The trade is illustrated in Figures 1 and 2.

Figure 1 - SPY OTM Butterfly

Figure 2 - SPY OTM Butterfly

A few key things to note regarding entering and managing this hypothetical position:

-There is approximately 8 months left before the options expire.

-The maximum risk is $410.

-If SPY takes out the recent low of 107.43 we might consider just cutting our loss.

-If SPY surprises everyone and shoots 20% higher between now and the end of March 2012 (stop laughing, it could happen) this trade would show a profit of over $900, or over +200%.

-A close look at the green line and black line in Figure 2 illustrates that after March 2012 time decay will start to work:

a) Seriously against this position if SPY is below about 144

b) Seriously in favor of this position if SPY is above 144

The bottom line is that this position has minimal dollar risk if the market tanks again and unlimited profit potential if something surprisingly good happens.

Summary

This example position clearly illustrates one of the potential advantages of trading options.  For a person who is having trouble mustering the gumption to dive headlong into the stock market (“Hi, my name is Jay”), this position affords the opportunity to profit if “somehow something goes right” and the stock market takes off to the upside.  All the while, the capital requirement and total amount of dollars at risk are minimal. 

While I remain “hunkered down” here in my office and peruse every “Europe/banks/world economy is soon to collapse” headline with a sense of fear and loathing, I cannot help also but to wonder what will the stock market do “if something goes right?”  It’s often been said that the stock market does whatever will confound the maximum number of investors. 

So ask yourself, how many people do you know who think the stock market will rally in any kind of meaningful way in the months ahead? 

Then listen for the sound of crickets…….

Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”

Optionetics.com ~ Your Options Education Site 

NOTES:

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