With the market in correction, many analysts have a price target of 3300 for the S&P 500. That's equivalent to 330 on the SPDR S&P 500 ETF. Today we'll structure a butterfly spread option trade centered around the SPY ETF. It profits if the S&P 500 falls to that 3300 level in the next five weeks, down from about 3632 today.
Butterfly Spread On S&P 500
A butterfly spread is a limited-risk and limited-profit trade. A typical butterfly spread trade has a higher profit potential than there is for a potential loss. In this butterfly spread example with SPY, it's a lot higher.
Placing the trade out-of-the-money lowers the cost and helps make the trade asymmetric with a large profit potential.
Butterfly spreads involve 3 different option strike prices, all with the same expiration date. Investors can use either calls or puts to create them.
As we are placing the butterfly below the market, we will use puts in this case to reduce the risk of early assignment.
Here's the trade I'm looking at using options on the S&P 500 ETF with all legs expiring on Nov. 18:
- Buy one SPY 310 put at 2.10
- Sell two SPY 330 puts at 4.40 each
- Buy one SPY 350 put at 9.25
Managing The Trade
The total cost of this trade is $255. That is also the maximum loss potential on the trade.
But notice the maximum gain is much higher at $1,745. This calculation takes the difference in strike prices multiplied by 100 shares less the premium paid ($2,000 less $255).
If SPY doesn't get down to 330, I lose a little bit. But I have the potential for a large payoff if it does hit 330 in about five weeks' time.
For a trade like this, it either works or it doesn't. I'm prepared to lose the whole $255 if it doesn't work out.
Two recent bullish trades from this column stopped out in the last few days. This bull put spread on the Invesco Solar ETF ETF and this bull call spread on Nvidia could both be closed to minimize the losses.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
