In this week's video, what I want to do is share with you how to hedge for a stock market crash in 2018. Of course, you could modify some of these variables. I'm not saying there's going to be a stock market crash but those of you that are looking at things that may be a little bit overvalued, things may be stretched a little too high.
How do you invest a little amount of capital but still potentially profit from a downside move without exposing yourself?
That's what we're going to cover, and today we're going to talk about a little bit about the butterfly spread now.
Let's dig deeper into our butterfly spread
Looking at our trade grid here, thinkorswim platform, we'll do a butterfly spread strategy here on the SPX to give you some context of where the market is.
The question is how much of a hedge and how much protection do you want or how much of a move do you think we're going to pull back if you are bearish or if you're looking to protect yourself?
Let's take a look at setting up a spread on the SPX. You can, of course, set this up on the SPY but the SPX is a little more significant.
What I'm going to do here is go into the trading grid, we'll go in and populate the SPX.
It comes down to how much time you want. In this example, I'm going to go ahead and do 48 days, or I could make 83-day option contracts.
If I go out at the 48 days and I'll go ahead and right-click here, I'm going to go and buy, and we'll do a butterfly. We'll analyze the trade.
You can see how this is set up; it's a little funky. Let me make some adjustments for it so you could see what's going on here.
What we're doing here with a butterfly spread is we're selling two at the money or two contracts for the put side. You could do it on the call side if you want but we're selling too at the put side, and we're buying our wings for protection. That's the basic strategy in this butterfly spread.
I'll go ahead and spread these out on the wings, and you can see that the wings here don't have to be perfect.
You could see I have this butterfly spread and it looks like a weird kind of tent, a triangle tent.
The way that this works - one of the exciting things with butterflies, is because you're selling such sweet at the money or near or close to the money strike prices, that with time as you move the time forward you can see that we get outside of our range right here for profitability. That's one of the great things about this move.
So, as time moves forward, it continues to get closer and closer to this tent. Now, the most that you would make at that peak $3500 on an investment of 410. So, you're making eight times on your money. That's quite a lot, so you're not risking too much to be able to profit.
You can see as with time, if this doesn't even work out in your favor - if the market stands still, you're still up about a $154 on March 5th. If it moved higher, if the market moved to 2900, you're down about $280 for that hedge or for that insurance or for that strategy.
It could continue moving higher, and then you're out $400 here - of course, prices are shifting.
But with time, what happens is this gets closer and closer to expiration. You can see how this curve boom explodes so as long as you give it about ten days and then the market falls. Let's not be in Disneyworld or be unrealistic. You're not going to hit it perfectly at the peak and make your 3500. Let's be real and let's say within a week or two it starts to sell off while you make about $500 on about $400 worth of risk. So that's a pretty good risk-to-reward potential. I mean you're making doubling your money up based on the risk that you're putting on.
You can see how we're widening it a little bit longer but your potential to make more money increases. You make a little bit more okay from this strategy than from the last one because you're going a little bit wider out. So the risk of it working out in your favor is less the chance of it working out in your favor is less so you make a little bit more.
What you could do right here is again and you look at it is it moves right there. You're already making $800 whereas the last ones like $500.
You actually can be profitable if it goes past your point even at 2600. You're still making money and also if on the outside over here you're again making money. So don't think of just the expiration curve, look at the white line which is your today line.
You can see how it works and it operates right there in a couple of weeks time. You could. If you had a hundred point move down, you could make about $1,500. Even if it blew past it, you could make $700.
Remember, nobody's going to give you anything in the market, so that means this leg went down. So you're risking more on capital here. That's 1160 because before it would be only 385. And over here 395. But now, if I move this up, I'm risking only 155. If the stock stands still but about $1000 on this side but you even with time, you can see continues to grow and grow and grow with the time decay. It allows you to protect yourself against the downside move or make some good capital.
Let's say you bump the contracts up to five contracts. That means you're selling ten, protecting five on one side and five on the other. Now you're talking about risking about $700. If we sell off right away, you make about $380, now this is, of course, doesn't account for the volatility.
If then you go ahead and do a few weeks of time decay, then you're up about an 1130 and then again a few weeks later up about 3600, but if it just stands still while you're risking your 750 to make about your 3,000 and indeed at the peak, but you can make about $19,000 dropping it back down to one contract.
This is really how it works on a basic butterfly spread, and how you make a low-risk investment for a downside move in a butterfly.
Of course, you could adjust this even further and go to 2785. Now I'm risking only $50 for that same kind of potential, but of course, I'm risking on this side $1545.
I wanted to share this strategy with you because this allows time decay to work in your favor. Then with time, you could see that for that $60 - if you had a hundred point move, you're making about a thousand bucks.
Keep in mind they'll margin you out the 1,500 because that's the most you could lose in your broker account but overall if the stock stands still you're out forty bucks which are not a lot of money.
So, in either case, this is a helpful strategy if you're expecting a nice big downside move to hedge things without risking a lot of capital. I didn't cover the volatility side of the butterfly here. I just wanted to share with you the strategy and some of the basic setups for it. But you could see how you could play with this to create some interesting plan for a downside move.
Be open. Play with this first and again don't forget to account for the volatility because you will have to take those things into account when trading options.