Butterfly Season

This is the fifth installment of Fujisan’s series on option spread strategies.

Enjoy!

Mole

As we have 2 more weeks to go until May OPX, this is a perfect time to put butterflies and calendars on your favorite stocks.  These option strategies are the best way to play in the final two weeks of OPX to take advantage of both delta (price movement) and theta (time premium).

I will describe this in more details in a short while, but butterfly is NOT an advanced option strategy.  It sure has a lot of legs and looks complicated, but this is just a combination of two vertical spreads and if you know how to trade vertical spread, butterfly is just as easy as vertical spread – it’s just 2 more legs to deal with and you can place it in one order.

Also, if you are not trading ETFs, I would highly recommend that you go with calendar spread instead of butterfly.  Because butterfly has more legs to deal with, it’s much harder to get a good fill in regular stocks.

OPX Bull/Bear Cycle

There is one more reason to take directional trades 2 weeks before OPX.  Major indices typically go through bull/bear cycle in relation to OPX and there is a high probability that the market will make a turn on Monday, 2 weeks from OPX (which is this coming Monday).

I have been looking at at SPY’s intermediate peaks and valleys in relation to OPX and here is what I found out:

1. During the consolidation phase, SPY makes intermediate highs/lows on Monday right after OPX.  It will then go to the opposite direction, and make another highs/lows on Monday 2 weeks before OPX.  It repeats this price movements until the consolidation phase is over.  In other words, if you keep flipping your positions every other Monday, you would be very profitable.

2. During the trending phase, SPY accelerates to the direction of the trend toward OPX.  No whipsaw or flip flap.  If you simply hold on to your positions throughout this period, you would be very profitable.

Now, remember SPY’s big selloff on Monday (April 20) and then rallied for the remaining week and this week to shake out all the bears?  This is a sign that SPY is now in the “consolidation” phase and in a “Bull” cycle, as illustrated in the above chart.  This also indicates that, if this pattern holds, SPY will make another turn next Monday and going into “Bear” cycle.

Of course this in itself should not be used as a buy/sell signal, but if this is combined with other major indicators and buy/sell signals (as I will decribe in SPY below), this would create a very powerful statement.

Know Your Enemy

I am following Mole’s Sun Tzu theme here, but I have seen many of you (almost every day) complaining about MMs market manipulations.  Of course they manipulate the market because that’s their job!  Unfortunately we are in the trading business and we won’t be able to avoid it.  If you think that MMs are manipulating the market, go analyze it.  Find out what they are doing.  Find the “rules” that they are playing, and take advantage of them.  That’s what I did and if you know how to play with their own rules, instead of your own, you could consistently beat the market.

Bearish Option Strategies with Specific Target Price

SPY

OPX Target: 81
Exit: Hold your position until OPX or SPY hits 81
Stop: Close out your position by Friday if SPY didn’t move.

I laid out my SPY time analysis above and May 5th would be the exact 100% time extension from Jan 5th (60 days from Jan 5th high to Mar 6 low, and 60 days from Mar 6 low to May 5th).  This also coincides with my OPX bull/bear cycle analysis, and if this pattern holds, SPY could come down on Monday or Tuesday, and this is my expectation to get into the following trades.

(I’m sure that many of you know about this, but just to be clear – time analysis should be used in conjunction with other analysis and major indicators.  Time analysis alone won’t produce consistent trading results, but at this point when all the major indicators showing divergences and overbought conditions and yet the market is still hanging tough, I thought that I should throw in my time analysis to help timing the market.  It’s also worth mentioning that another Bradley’s cycle day is coming up on May 4th and 5th, and it seems to me that everything is lining up perfectly in harmony waiting for the market to turn.)

Please note, there are just examples based on Friday’s close.  If Monday started selling off hard, or making another higher-high, please consider different strike prices to maximize the risk/reward.

Recommended Strategy: 90/85 May Bear Put Spread
Probability: 51%
Cost: $2.35
Max Reward: $2.65
Risk/Reward: 113%

This is a 90/85 May bear put spread and good for a beginner and intermediate.  This spread is to buy 90 May put options and sell 85 May put options to create a vertical spread.  You make the most money at short strike of 85 and lower, and as long as SPY stays below 85 strike price, you should hold on to your position until OPX to earn time premium.

If you are putting a front month vertical spread on so close to OPX, please make sure that you buy an option deep in the money to mitigate theta risks (as you know, time decay accelerates exponentially toward the end of OPX week).

Recommended Strategy: 82 May/June Calendar
Probability: 46%
Cost:  $1.64
Max Reward:  $2.11
Risk/Reward:  129%

This strategy is good for an intermediate level.  This spread is to buy June 82 put options and sell May 82 put options to make a calendar spread.  You make the most money at May short strike at 82 and as long as SPY is within the breakeven point of 77 and 88, you should hang on to your position to enjoy positive theta, but once SPY passed the short strike of 82, you might as well close your position to take a profit.

One of the advantages of calendar spread is that, if the trade goes against you, you could get out of the position with a small loss.

Recommended Strategy: 74/82/90 May Butterfly
Probability: 50%
Cost: $2.58
Max Reward: $5.76
Risk/Reward: 258%

This strategy is good for an intermediate level.  This spread is a combination of a put debit spread of 90/82 (to buy 90 put options, sell 82 put options) and and a put credit spread (to buy 74 put options and sell 82 put options).  You make the most money at the short strike price of 82 and as long as SPY is within the breakeven point of 76 and 88, you should hang on to your position and enjoy positive theta.  But once SPY passed the short strike of 82, you might as well close your position to take a profit.

Don’t be intimidated with all these legs.  If you could just put it on as one position (which TOS platform would let you), that’s all you need to manage.  If you have to place an order separately, just call up the help desk to describe this position and ask them to put it on.  You don’t need to worry about legging in and out.  If the trade goes against you, simply close your position and walk away.

Lottery Ticket: 78/81/84 May Butterfly
Probability: 21%
Cost: $0.25
Max Reward: $2.74
Risk/Reward: 1009%

This butterfly is a total speculation and “lottery ticket play” in my opinion, but once in a while, it’s OK to play with lottery ticket, especially when you have such a good risk/return ratio.

You make the most money at a short strike of 81, and you might as well close your position once SPY get close to 81.

As the premium is so small, please be prepared to lose all your premium if it does not hit it right in the middle of the short strike.  This is the type of trade that you would like to explore more often as this is possible only with option.

QQQQ

OPX Target: $31.5
Exit: Hold until OPX or QQQQ hits 32
Stop: Thursday High (or Monday High, if it goes higher on Monday)

Recommended Strategy: 35/32 Bear Call Spread
Probability: 51%
Cost: $0.80
Max Reward: $1.20
Risk/Reward: 150%

This is a 35/32 May bear put spread and good for a beginner and intermediate.  This spread is to buy 35 May put options and sell 32 May put options to create a vertical spread.  You make the most money at short strike of 32 and lower, and as long as QQQQ stays below 32 strike price, you should hold on to your position until OPX to earn time premium.

If you are putting a front month vertical spread on so close to OPX, please make sure that you buy an option deep in the money to mitigate theta risks (as you know, time decay accelerates exponentially toward the end of OPX week).

Recommended Strategy: 35/32/29 May Butterfly
Cost: $0.80
Probability: 48%
Max Reward: $2.18
Risk/Reward: 272%

This strategy is good for an intermediate level.  This spread is a combination of a put debit spread of 35/32 (to buy 35 put options, sell 32 put options) and and a put credit spread (to buy 29 put options and sell 32 put options).  You make the most money at the short strike price of 32 and as long as QQQQ is within the breakeven point of 29.7 and 34.2, you should hang on to your position and enjoy positive theta.  But once QQQQ passed the short strike of 32, you might as well close your position to take a profit.

Don’t be intimidated with all these legs.  If you could just put it on as one position (which TOS platform would let you), that’s all you need to manage.  If you have to place an order separately, just call up the help desk to describe this position and ask them to put it on.  You don’t need to worry about legging in and out.  If the trade goes against you, simply close your position and walk away.

Lottery Ticket: 31/32/33 May Butterfly
Probability: 21%
Cost: $0.09
Max Reward: $9.06
Risk/Reward: 1007%

This butterfly is a total speculation and “lottery ticket play” in my opinion, but once in a while, it’s OK to play with lottery ticket, especially when you have such a good risk/return ratio.

You make the most money at a short strike of 32, and you might as well close your position once QQQQ get close to 32.

As the premium is so small, please be prepared to lose all your premium if it does not hit it right in the middle of the short strike.  This is the type of trade that you would like to explore more often as this is possible only with option.

That’s all for today and I hope you enjoyed my butterfly option strategies.  We are finally getting a nice weather here in Seattle and I am enjoying a beautiful butterfly season.

Fujisan