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What are your options - S&P 500 defined risk strategies
Koen Hoorelbeke
Investment and Options Strategist
Summary: In the aftermath of the downgrade of the US Goverments Triple A rating to AA+, the article discusses three advanced, defined-risk strategies - the Bullish Broken Wing Put Butterfly, Neutral Iron Condor, and Bearish Broken Wing Call Butterfly - that could potentially help traders profit from the resulting heightened market volatility.
What are your options - S&P 500 defined risk strategies
In the aftermath of Finch's downgrade of its Triple A rating to AA+, there has been a noticeable impact on the S&P 500, with the index experiencing a downward correction. This downgrade has induced a spike in volatility, with the VIX index briefly peaking above 17 before settling just below 16. Consequently, this heightened volatility has led to an escalation in the premiums paid for options on the SPX.
Here are 3 defined risk strategies (bullish, neutral and bearish) which, depending on your view will let you profit of this elevated volatility.
1. Bullish: Broken Wing Put Butterfly
2. Neutral: Iron Condor
3. Bearish: Broken Wing Call Butterfly
These defined risk strategies are chosen in such a fashion that whatever happens the outcome is "predefined". They are considered "advanced", since they each consist of a combination of 2 vertical spreads. To minimize the risk involved we perform them on the SPX-index itself (and NOT f.e. on the SPY, which is an etf representing the S&P500). Using index-options we avoid assignment-risk and everything is cash-settled. An important stress-reducing factor.
Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.
1. Bullish: Broken Wing Put Butterfly
The first strategy we'll be learning is a called a "Broken Wing Butterfly". A BWB as we'll call them is possible in 2 "flavors" the Put and the Call. The Put-version is bullish. This is the one we'll be discussing now.
A broken wing butterfly spread is an advanced options strategy that involves combining a debit and a credit spread. The goal is to establish a trade where you have a high potential reward with a defined risk.
Here's how it works:
1. Buy an in-the-money (ITM) Put: This is typically your long Put with the highest strike price. This is the debit side of the trade because it costs you money.
2. Sell two at-the-money (ATM) Puts: These are your short Puts with the middle strike price. Selling two Puts generates premium income that pays for the long Put you bought. This is a credit spread.
3. Buy an out-of-the-money (OTM) Put: This is your long Put with the lowest strike price. The strike price for this option is further apart from the two short Puts than the distance between the two short Puts and the long Put. This is where the "broken wing" comes in, as it breaks the symmetry of a traditional butterfly spread.
The strategy is designed to make a profit in a specific range of prices and has a built-in downside protection (which is the benefit of the "broken wing"). If the underlying price stays close to the middle strike price (the price of the short Puts) at expiration, the strategy can yield the maximum profit. The profit is limited to the difference between the strikes of the long and short Puts plus the net credit received or minus the net debit paid to establish the position.
If the underlying price moves significantly away from the middle strike price, the trade can incur losses. The losses are limited on the upside because of the OTM Put you bought (that is your maximum risk if the price goes up), but on the downside, it is limited to the difference between the higher strike short Put and the long Put minus the premium received.
Now let's have a look at the actual setup:
You're looking at a Put Broken Wing Butterfly strategy on the S&P 500 Index (SPX:xcbf) with a setup for the September 15, 2023 expiry.
1. Strategy: The Put Broken Wing Butterfly involves buying one in-the-money (ITM) put, selling two at-the-money (ATM) puts, and buying one out-of-the-money (OTM) put. This strategy is used when a trader believes the underlying security will remain within a certain price range until expiration, and is looking to profit from the premium decay.
As described above a broken wing butterfly has normally it's short legs (the sold puts in this case) ATM. In this case we'll put the short legs (the sold puts) a bit lower of the current/last traded price. This will give us some sort of a cushion if our bullish view is invalidated. So, as long as we stay above 4350, we're safe.
2. Trade Setup: The specific trade here involves:
- Buying one put with a strike price of 4400.
- Selling two puts with a strike price of 4350.
- Buying one put with a strike price of 4250.
3. Premium and Risk: The net premium for this setup is $2.90 per share, giving you a credit of $290. The maximum risk for this trade is $4710, which will occur if the S&P 500 moves significantly beyond the 4250 strike price at expiration. On the other hand, the maximum profit potential is $5290, which will be realized if the S&P 500 is at the short strike ($4350) at expiration.
4. Breakeven Point: The breakeven point is 4297.1, indicating that as long as the S&P 500 is above this level at expiration, the trade will at least break even.
5. Implied Volatility (IV) Rank: The IV Rank is 27.96%. This can be interpreted as the current level of implied volatility is higher than approximately 28% of its readings over the past 52 weeks.
6. Days to Expiration (DTE): The time until expiration for these options is 42 days.
The goal of this strategy is to collect the premium, while the underlying (the SPX) continues to move upward. As we collect $290,- on a €860,17- (= +/- $942) margin requirement over a period of 42 days, this yields us approx. 30.7% return in 42 days or an annualized return of around 266%.
In case the SPX goes south and opposite of what we expect it will first pass the "cushion" area (the area where we sold our puts), where it will yield it's maximum result at expiration. If it goes beyond that (= below the breakeven point) our strategy will result in loss. Depending on the time where we are we can exist early and limit our losses. If you do nothing and the price goes below the 4250 long put, this strategy will result in the maximum loss.
2. Neutral: Iron Condor
The second strategy we'll be looking at is the Iron Condor. An Iron Condor is an advanced options trading strategy that is designed to generate a consistent return with a high probability of success, when the expectation is that a stock or index will have lower volatility at/near expiration. The strategy involves four different contracts with the same expiration date but different strike prices.
Here's how it works:
1. Sell an out-of-the-money (OTM) Put: This is a short Put at a strike price below the current price of the underlying asset. You receive a premium for selling this Put.
2. Buy an OTM Put at an even lower strike price: This long Put serves as protection in case the price of the underlying asset drops significantly. You pay a premium for buying this Put, but less than what you received for selling the first Put. The difference between the strike prices of these two Puts forms the Put spread.
3. Sell an OTM Call: This is a short Call at a strike price above the current price of the underlying asset. You receive a premium for selling this Call.
4. Buy an OTM Call at an even higher strike price: This long Call serves as protection in case the price of the underlying asset rises significantly. You pay a premium for buying this Call, but less than what you received for selling the first Call. The difference between the strike prices of these two Calls forms the Call spread.
So, an Iron Condor consists of two vertical spreads: a Put spread (for downside protection) and a Call spread (for upside protection), both for the same underlying asset and with the same expiration date.
The maximum profit for an Iron Condor is the total premium received for selling the Call and Put spreads (minus commissions). This occurs if the price of the underlying asset is between the strike prices of the short Call and short Put at expiration.
The maximum risk or loss is the difference between the strike prices of either the Calls or the Puts (they should be the same) minus the net premium received.
Iron Condor trades are a good way to generate income in a non-volatile market, but they also require careful management due to the potential for significant losses if the price of the underlying asset moves too much in either direction.
Now let's have a look at an actual setup:
1. Trade Setup: The setup involves four options on the S&P 500 Index:
- Buying an out-of-the-money 4800 Call (expiring 15-Sep-23)
- Selling an out-of-the-money 4700 Call (expiring 15-Sep-23)
- Selling an out-of-the-money 4300 Put (expiring 15-Sep-23)
- Buying an out-of-the-money 4200 Put (expiring 15-Sep-23)
2. Premium and Risk: The net premium received from establishing this trade is $1980. The maximum risk, or the most you could lose on this trade, is $8020. This maximum loss occurs if the price of the S&P 500 at expiration is either above 4800 or below 4200.
3. Breakeven Point: The breakeven points are 4280.2 and 4719.8. Any price of the S&P 500 at expiration between these two points will result in a profit from the trade.
4. Probability of Profit (POP): The Probability of Profit (POP) is 67.87%. This is a rough estimate of the chance that the trade will be profitable at expiration. Please note that this is a simplification and actual probability may vary based on factors like changes in implied volatility or the price of the underlying asset. The POP is based on the delta.
5. Implied Volatility (IV) Rank: The IV Rank is 27.98
6. Days to Expiration (DTE): The options involved in this trade are set to expire in 42 days. This is the period within which the expected price stability should occur for the trade to be profitable.
7. Expected Move: $168.15, based on a ATM straddle with expiration on 15 September 2023.
3. Bearish: Broken Wing Call Butterfly
The last strategy we'll discuss is actually the opposite of the first one we discussed: a broken wing butterfly but with calls, rather than using puts.
Let's have a look:
1. Strategy: The strategy used here is a Broken Wing Call Butterfly, which is a type of options strategy that combines two vertical spreads to create a range where the trade can profit, while eliminating the risk on one side of the range. The strategy is designed to profit from a rise in the underlying asset's price but up to a certain level.
2. Trade Setup: The setup involves three call options on the S&P 500 Index:
- Buying an out-of-the-money 4700 Call (expiring 15-Sep-23)
- Selling an at-the-money 4600 Call (expiring 15-Sep-23)
- Buying an in-the-money 4550 Call (expiring 15-Sep-23)
3. Premium and Risk: The net premium paid for establishing this trade is $520. The maximum risk, or the most you could lose on this trade, is $4480. This maximum loss occurs if the price of the S&P 500 at expiration is below 4550.
4. Breakeven Point: The breakeven point is 4655.2. Any price of the S&P 500 at expiration above this point up to the higher strike price will result in a profit from the trade.
5. Implied Volatility (IV) Rank: The IV Rank is 27.98, suggesting the implied volatility is relatively low. This could impact the premiums of the options, but could also suggest a stable price range for the underlying asset.
6. Days to Expiration (DTE): The options involved in this trade are set to expire in 42 days.
The goal of this strategy is to collect the premium, while the underlying (the SPX) continues to move downward. As we collect $520,- on a €2817.52- (= +/- $3085,-) margin requirement over a period of 42 days, this yields us approx. 16.8% return in 42 days or an annualized return of around 146%.
In case the SPX goes up and opposite of what we expect, it will first pass the "cushion" area (the area where we sold our calls), where it will yield it's maximum result at expiration. If it goes beyond that (= below the breakeven point) our strategy will result in loss. Depending on the time where we are, we can exist early and limit our losses. If you do nothing and the price goes below the 4700 long call, this strategy will result in the maximum loss.
In conclusion, with the increased volatility in the market following the Finch-rating-downgrade, adopting advanced, defined-risk strategies is a beneficial approach to navigate and potentially profit from the situation. The three outlined strategies, namely, the Bullish Broken Wing Put Butterfly, Neutral Iron Condor, and Bearish Broken Wing Call Butterfly, offer opportunities for traders and investors to profit under different market expectations, with a predefined outcome to minimize risk.
These strategies exemplify how understanding and leveraging market volatility, option pricing, and advanced trading strategies can provide opportunities for profit in various market conditions. As always, these strategies should only be used after careful consideration of individual investment goals, risk tolerance, and market conditions. An informed and disciplined approach is crucial to success in these complex trading strategies.
Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website.
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