After holding a couple of free live webcasts over the past month discussing earnings trades and adjustments, here’s yet another look at an “income” type of trade. This one popped up as a trade yesterday as the VIX starting pushing 15. But the reason for the move up in volatility becomes a two-edged sword.
The minutes from the last Fed meeting come out on Wednesday. This could either be a completely benign event and the market will do nothing; or perhaps continue this mindless rally. Or something in the minutes, probably talk of tapering, could send an overbought market lower. It’s this latter scenario that holds the risk for this trade, which is the SPX Aug5 (August 30 expiry) 1610-1605-1595 put broken wing butterfly for a 40-cent credit.
The VIX at 15 certainly isn’t any huge volatility spike, but it’s certainly higher than 12. This little move higher in the VIX can actually make a big difference in how these broken wing butterflies set up, and also how they can play out. With this particular trade, the concern is how much of a sell-off this trade can handle before it approaches the loss exit threshold.
Traders that are newer to this strategy often mistakenly believe that this trade only “works” if the index moves to the short strike, which in this example is 1,605. And the expiration risk graph is what traders also mistakenly rely on for managing this trade. What’s more important, though, is how the trade unfolds over time.
This risk graph shows a relatively accurate picture of how the trade can work over the next 10 days (but we know reading the option chain is a better way). Each successively higher line represents a time in the future as this trade approaches expiration. The blue arrow shows the effect of the index moving lower as time passes, and how the trade profits before reaching the short 1605 strike. If the index moves down too quickly, then the trade starts to lose.
As my old football coach used to say, “If you want to be 3-0, you first have to get to 1-0.” Three days later for this trade doesn’t matter much if it can’t survive tomorrow, right? So here’s where knowing volatility, the expected range, the greeks, the change in the greeks; and understanding the market you’re in, is far more valuable than anything you can glean from your risk graph.
With my analysis I figured this trade, through one day, is fairly safe through a two-standard deviation move. If the Fed minutes throws the market into a tailspin, this trade can reasonably be expected to survive. By that I mean the trade should not hit a loss exit of 20%.
Notice how the broken wing can profit more than the initial credit prior to expiration. That’s why with a broken wing you can collect the credit (or more) closing the trade prior to expiration. That’s something that just won’t happen with a short put spread.
Take a look at the Broken Wing Butterfly series below. It comes with one-hour of personal mentoring with me. And for a short time I’m including a second free hour to go over the broken wing butterfly spreadsheet that I use to compare trades.
Trade safe!
Greg Loehr
No relevant positions.
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