Hello everyone! It’s great to have a few minutes today to share with you all the great news of Jesus. In recent weeks my pastor has asked me to speak at our small church and the sermon I prepared was in regards to suffering or the evil in this world. I believe, at some time or another, we’ve all asked this question or some version of it, “why is this happening”? It just doesn’t seem right that God would allow so much pain or hardship. Truthfully, I ask that question often but after some prayer and research what I found was remarkable. Rather than try and explain it completely here, check out this Youtube video from IMBeggar that I think beautifully answers that very question better than I ever could.
Turning our attention back to options trading, I’ve been testing variations to the broken wing butterfly and what I’ve cooked up is quite interesting. You may remember my post from a few weeks ago titled, “Ratio Spread Hedge – Hope for the Best, Prepare for the Worst!” where I discussed using futures options to hedge a portfolio. Well, it got me to thinking, why not hedge my options with a futures option.
Therefore, in today’s post I want to take a look at an income generating strategy using the broken wing butterfly on SPY while simultaneously coupling it with some downside protection.
Post Agenda
Broken Wing Butterfly & Futures Put Option
The first thing you’re likely wondering is why a futures put rather than just a further OTM SPY put? And that’s a reasonable question. However, what I’ve found is that a long /MES futures put is about half the cost of its SPY counterpart. As such, we’re essentially able to get the same downside protection at half the cost. Let me explain the full concept below.
I tested several variations to the butterfly spread but what I landed on was a bullish SPY put broken wing butterfly with the widest wing being $10. Admittedly, you may read this and decide to alter the structure which is perfectly fine. No matter how wide the strikes, the end goal is to collect enough credit to buy the futures put and also make a small profit if price doesn’t fall.
First, construct the broken wing butterfly similar to the image below. You’ll want to go close enough to the money that the credit is sufficient but not so close that the downside impact is immediate. I’ve been targeting around a 30 delta but that’s just my own opinion. You’ll likely want to experiment with several variations yourself to find a suitable balance.
Image 1.1
You’ll notice in this instance I’m able to construct a relatively high probability SPY put broken wing butterfly. Specifically, there is about an 80% chance of success with this trade. Now, let’s couple that with a /MES futures put option and see how it looks.
Image 1.2
It isn’t visible from the image above but I had enough credit to purchase the 4740 strike put and still leave a potential profit of $18.25 if the price goes higher or moves only slightly lower. Next, you’re probably looking at that long flat area that is still the max loss on the SPY put broken wing butterfly. True, but the story isn’t complete from that image alone. Should price retrace into that area we would be looking at somewhere between a 6% – 16% move to the downside. Generally, a move of that magnitude would also be coupled with a volatility spike. To account for that, take a look at this image using ThinkorSwim’s Vol step function.
Image 1.3
Notice in the second image a move to the $510 level tomorrow would have resulted in about a $107 dollar loss. However, when factoring for volatility you’ll see that even a slight 5% volatility increase pushes the strategy into profit. I left the cursor hovered over the $510 area so you could see the result in the bottom left box. Should volatility increase more than that the profit really begins to stack up.
Sure, there isn’t any telling what the market may do but by constructing such a trade we’re at least managing it to the best of our ability. With that, let’s consider our options as they relate to managing the position.
SPY Put Broken Wing Butterfly Strategy Management
There are two considerations to this strategy I’d like to discuss. First, we could simply manage the position by closing the entire position at our profit target/stop loss or upon expiration. The primary objective here would be to make sure the trade had achieved sufficient profit. That would be the easiest route to take.
Alternatively, we may attempt to keep the long put on our books once the SPY put broken wing butterfly had fully paid for the put. In this scenario, we could be leaving that $18 dollars of profit on the table but would be further enhancing our downside protection on our next broken wing butterfly. Possibly opening the door to a closer to the money broken wing butterfly and thus a considerably larger credit.
Again, these are just ideas and I haven’t live tested the strategy together in this form so do be cautious. I think the biggest risk is a stagnant to grinding lower market. If volatility doesn’t increase, price doesn’t fall enough, or price doesn’t rise, the SPY put broken wing butterfly and the long /MES put could both end up in unprofitable territory. Ouch!
Although, and this is a big although, I have also considered a /MES long put vertical. This would allow me to move closer to my butterfly and minimize that max loss area of the butterfly. But, it also minimizes the dramatic increase in profit from a volatility spike. In either case, that’s just some more food for thought.
Final Thoughts
In all I think the strategy could perform well and it could likely be altered in several different ways to increase the appeal from one direction or another. Maybe this week we’re very bullish and want to improve our income. We could easily move our SPY put broken wing butterfly closer to the money. This would provide a larger credit, less downside risk, and the ability to move our long put closer to the money. Alternatively, if we we’re particularly bearish we could easily move our butterfly lower and increase or probability for a lesser credit.
Only time or testing will determine the strategies effectiveness and honestly we may just be better served choosing one of the strategies over the combination of them. However, if you’ve ever experienced a run away downside market while in a position I can assure you this looks much more appealing. Should price fall off a cliff, that long put has the beautiful advantage of unlimited profit. And that will likely always be appealing.
In any case, hopefully you enjoyed the strategy and I hope you have fun testing it yourself. Until the next post.
God bless,
Jeff
