With the market in a correction and many analysts putting a price target of 3300 for the S&P 500, today we are looking at a butterfly trade on SPY stock centered at that level.
A butterfly is a limited risk and limited profit trade. But on a typical butterfly trade, the profit potential is higher than the potential loss. In this case, it's a lot higher.
Placing the trade out-of-the-money means it can be done for very low cost with a large profit potential.
Butterfly spreads involve three different option strike prices, all within the same expiration date, and can be created using either calls or puts.
Because we are placing the butterfly below the market, we will use puts in this case to reduce the risk of early assignment.
Breaking Down Butterfly Trade
Here's the trade on the S&P 500 SPDR ETF I'm looking at:
Buy one July 15 expiry, 310-strike put at 0.45
Sell two July 15, 330 puts at 1.00
Buy one July 15, 350 put at 2.80
The total cost of this trade is $125 and that is the maximum loss potential.
The maximum gain is $1,875, which is calculated by taking the difference in strike prices less the premium paid ($2,000 less $125).
Big Potential Payoff In 3 Weeks
If SPY stock doesn't get down to 330, I lose a little bit, but still have the potential for a large payoff if it does hit 330 in about three weeks' time.
For a trade like this, it either works or it doesn't, and I'm prepared to lose the whole $125 if it doesn't work out.
This VIX trade from last week is working out well so far and has achieved around half the profit in one week.
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
