Butterfly Option Trade: The following is from a Barrons article by STEVEN M. SEARS

Butterfly Option Trade on Sprint

IF THE FEDERAL RESERVE can print money, so can you. All you need is a little cash, and a ton of nerve.

Consider Sprint Nextel (ticker: S). The $4 stock is a dog; it has declined 12% in the past three months, and yet trading volumes are surging, demonstrating that distressed equities – what institutional investors call penny stocks – are incredibly alluring in this market because of the potential to make double- or triple-digit returns on small price movements.

If you want to make a potential 500% return on one trade, Credit Suisse advised clients Tuesday to position for Sprint to move to $5 by January.

The bank told institutional clients to consider a “call fly” that entails buying January $4 calls and January $6 calls, and selling twice as many January $5 calls.

With the stock around $4, the “call fly” costs 20 cents. If Sprint closes at $5 on January expiration, the 20-cent ante is worth $1. If Sprint tumbles, traders lose the entire 20 cents, but who cares about chump change like that?

To be sure, the past few days have been intoxicating for many traders who seem stunned at how much money they’ve made since the second phase of qualitative easing (QE2) bull market began.

The demand for limited-risk, very high-return options trades suddenly seems insatiable as the traders interpret the Federal Reserve announcement last week of QE2 as a raging buy signal for stocks. Why? Because the Fed’s decision to buy Treasuries and further depress interest rates lowers the value of bonds, and effectively shoves investors into riskier assets such as stocks that offer capital appreciation and dividends higher than bonds.

Butterfly options trading

Various options-trading-desk chatter invariably revolves around how investors can lock in gains and take advantage of incredibly inexpensive put options as fear has exited the market. But the backroom talk that is usually not meant for public dissemination revolves around how to make outsized returns during the six-month period of QE2. After QE2 ends, who knows what will happen? Until then, there is little perceived risk in buying stocks. Of course, such logic always ends in a veil of tears, but. . .

The “bulled up” logic of QE2 permeates many low-priced stocks, including Citigroup (C) and Augusta Resource (AZC), a copper miner. All traders know the “flight to crap” is a sign of frothy markets, but bubbles be damned, as the only ones who cry about burst bubbles are those who don’t know when to sell and take profits.

GO WITH THE FED

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