In Part 1 I wrote about a simple hedging strategy known as the Out-of-the-money (or OTM) put butterfly spread.
In the example I showed the trade reached its maximum profit if ticker SPY declined in price by two standard deviations. There is one additional point to be made regarding this strategy: Once that maximum profit potential price is reached a trader should consider taking profits or adjusting the trade. To understand why please see Figure 1.Figure 1 – SPY OTM Put Butterfly “rolls over” at $193 per share (Courtesy: www.OptionsAnalysis.com)
As you can see in Figure 1, while profits climb as price declines between 210 and 193, once price falls below 193 the profit profile “rolls over” and starts to head back down. So a trader who enters into any directional butterfly type spread needs to pay attention to the trade while it is open and be prepared to act if price reaches the middle strike price for the butterfly spread.
“Open Ending” Profits
For a trader who is willing to put more money into a trade there is a simple alternative that creates an OTM butterfly that enjoys unlimited profit potential. Figure 2 displays the same position as above (long June 210 put, short June 193 put and long June 176 put). However in this case:
*Instead of a long 1 210, short 2 193 and long 1 176 position
*The trade holds a long 2 210, short 3 193 and long 2 176 position
The risk curves for this new trade appears in Figure 2.
Figure 2 – SPY Directional (2 x 3 x 2) butterfly spread (Courtesy: www.OptionsAnalysis.com)
Instead of $244 for a 1 x 2 x 1, this 2 x 3 x 2 position would cost $551. The key difference however is that the trader holding the 2x3x2 position does not have to be concerned about SY falling “too far” and turning a winning trade back into a loser as is the case with the 1x2x1 position in Figure 1.
So which position is better – 1x2x1 or 2x3x2. As you might expect me to say, there is no “correct” answer. If you think:
A) A standard “market correction” is in the offing
B) Are looking for a “cheap hedge”
C) Are willing to act if price reaches middle strike price
D) And/or if you don’t expect the middle strike price to be reached
Then the 1x2x1 is an excellent choice.
On the other hand, if your goal is to hedge against “something worse” – i.e., a deep sell off or even a market “crash” then the 2x3x2 affords you unlimited profit potential and alleviates any concerns about your position “rolling over” and turning back into a loss – at a price.