Option Butterfly Spread Being Used As A Hedge

Option Butterfly Spread: A friend emailed me the following. It was taken from an email commentary sent out by OptionsXpress.com

“The biggest options trade in the market so far Wednesday (1-12-11) is a block of 80,000 February 121 puts on the SPDR 500 Trust (SPY). The so-called “Spyders” is an exchange-traded fund that holds all of the S&P 500 stocks and is up $1.15 to $128.59. The big block of February 121 puts was part of an options strategy called a butterfly spread. In this position, the strategist sold 80,000 February 121 puts, bought 40,000 February 126 puts and bought 40,000 February 116 puts. They paid a net debit of 53 cents per fly. This butterfly is a directional play, as it makes its best profits if shares fall to $121 by the February expiration. An institutional option investor probably initiated the spread as a hedge.”

SPY closed today at 128.36
If you got into this trade at the close, the breakevens would be 116.55 and 125.40.

So this trade could be a bearish bet, or it could be a hedge. If it is a bearish bet it stands to make several hundred percent if SPY does indeed retreat close to 120 on Feb expiration.

If it is a bearish play, then for a pretty cheap price, (57 cents debit) the options trader can give himself nice way to protect his portfolio. If the market goes up, his main portfolio makes enough to offset the loss of this trade. If the market drops, the trader will lose on his main position, but make up most of it on the gain in the butterfly.

Notice that the trader used Feb expiration. So we can guess that this trader is worried about something happening before Feb expiration. My guess is earnings.

As you can see, adding a butterfly or other option strategy is a good, cheap way to insure your portfolio against losses.

Butterfly Spread Hedge

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12 Comments

  1. Gavin McMaster on January 16, 2011 at 1:37 pm

    Great article Allen. I have never tried this strategy before but it seems a great way to protect your portfolio especially at a time like this after a long market run up. Thanks for the info, keep up the good work.

  2. keshav on January 18, 2011 at 3:09 pm

    good strategy, let us see how it works out.

  3. Larri Allen on January 18, 2011 at 5:19 pm

    Interesting article since it purportedly is a re-print from optionsXpress, whereas the risk graph appears to be from Think or Swim! How come?

    • Genius on January 18, 2011 at 5:47 pm

      The article is from optionxpress, I made the risk graph from my tos account. For multiple reasons I have account at several brokers including, optionsxpress, thinkorswim, eoption, interactive brokers, and trademonster.

  4. Anil on January 18, 2011 at 11:52 pm

    Very Nice

  5. Curt Arnspiger on January 19, 2011 at 12:47 pm

    Allen, I have an account with Tradeking. What are the reasons for having accounts with so many firms? Do you have an opinion on Tradeking as a brokerage?

    • Genius on January 19, 2011 at 2:03 pm

      I havent used TradeKing but havent heard anything bad about them either. We tried to set up autotrade with them in the beginning but their autotrade could not accept orders with 3 or 4 legged trades. Don’t know if they have changed that yet.

      I have multiple accounts for many reasons. I open the IB account because I wanted to trade futures options but their system is very complicated and I am looking at switching that account to optionsxpress. I have an account at eoption which is autotraded by optiongenius to make sure the trades and such are done properly. I have retirement accounts at fidelity which i never bothers to move to a cheaper broker but have thought about it several times. I have a large account at trademonster where i trade 100’s of contracts per trade and their .50 per option saves me money. And I like thinkorswim for their software.

      • curt on January 20, 2011 at 4:27 pm

        Thankfor the info. What is auto trade? I have 10 accounts at Tradeking for vaious IRAs and coverdell accounts as well as my main trading account. It would be nice to be able to enter trades on one screen and have them executed in multiple accounts.

        Curt

        • Genius on January 24, 2011 at 2:57 pm

          Autotrade is where the broker executes trades for you in your account when you tell them to follow an advisory or service for you. What you mention is something different where are the trades are linked together. You will have to call tradeking to see if they can do that for you. I know thinkorswim allows it, but you have to call and work with them to get it set up. if they do, other brokers probably do it as well.

  6. Cyriac Kandathil on January 20, 2011 at 8:29 pm

    I do not think that it is a hedge.Breakeven for this strategy is at 125.47.If SPY closed at 125.47 on February expiration the investor would lose (128.36-125.47)*80000=2.89*80000=$231200. This is a lot of money to lose.This loss is permanently there till SPY reaches 121.Then the loss accelerates due to short puts at 121.To me it is no hedge at all.There is no compensation as it is.Who ever wrote this must review this strategy and see the fallacy of his statements.
    Cyriac Kandathil

    • Genius on January 24, 2011 at 2:59 pm

      It could be a directional bet, but that seems highly unlikely. As you said, if it does not work out, the trader losses the whole amount of the trade. i dont see an institutional investor risking that much without having something on the other side to mitigate the risk.

  7. Cyriac Kandathil on February 15, 2011 at 12:21 am

    This month also a similar trade has been set up for another index. But the trade is for March expiration. It seems that the same party is taking this risk.Option Express again is telling that this could be a hedge. I do not understand their logic.
    To me it is a directional and the party is expecting a sharp fall in the coming months.The trade off is 1:10 and hence even if he losses 9 out of ten months he could be a big winner.
    Anyway whoever it is he losing $1 milion every month if market does not fail.
    Cyriac

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