Using a Butterfly Spread to Reduce Downside Risk

At Terry's Tips, we have been researching the possibility of using butterfly spreads to provide downside protection for our 10K Strategy. As you may recall, the 10K Strategy uses calendar spreads at several different strike prices and depends on premium decay to generate gains most every month.

This strategy has made exceptional gains when the market is stable or fluctuates moderately either up or down, but has experienced losses when a large drop occurs. The last couple of weeks have been painful for this strategy because many have dropped nearly 10% quickly.

This week we are establishing a new portfolio for Terry's Tips Insiders to follow if they wish. It is called the Mighty Stalagmite. It uses SPY (the S&P 500 tracking stock) as the underlying because this is a large and relatively stable index.

The key feature of the Mighty Stalagmite is that a butterfly spread is added to the calendar spreads to provide downside protection in case the stock moves more than moderately during the expiration month.

Brief Description of a Butterfly Spread: A typical butterfly put spread would be as follows:

Long 10 Aug08 132 puts
Short 20 Aug08 127 puts
Long 10 Aug08 122 puts

Total cost of this butterfly spread = $1.10 ($1100 for 10 spreads)

This is the risk profile graph for these positions:



The butterfly spread gets its name because a graph of its returns are supposed to look like a butterfly, but it never looked that way to me.

The maximum gain for a butterfly spread comes when the stock ends up exactly at the strike of the short options. If it lands there, a very large gain results (in this case, over 4 times the cost of the spread). There are some interesting aspects of butterfly spreads:

o The initial cost is your maximum loss.
o If the stock ends up above the highest strike or below the lowest strike, a total loss results.
o The closer the mid-point (the short option strike) is to the stock price when it is bought, the more expensive it is (if the above butterfly were bought with all the strikes 5 points lower, the spread would cost $.53 instead of $1.10).

Since we would like to use a butterfly spread to provide protection on the downside, we would select a mid-point at a strike much lower than the current price of the stock. If the stock falls more than moderately so that the mid-point strike is approached, a large gain could occur which would offset the loss on the calendar spreads from the falling stock price.

If we added a butterfly whose mid-point was 10 points lower than the original stock price, it would only cost $.50 or so (this compares to the $3.00 or so in premium decay we would be collecting from the at-the-money options we have sold in the calendar spreads). Conceptually, we would be giving up some of our potential decay gain to provide excellent protection in case the stock were to fall by a large amount.

Most investors use calls when placing butterfly spreads rather than puts, and often take off some of the positions if the market moves strongly in either direction. Usually they are placed with the short strikes close to the current market price so that the maximum gains come when the market is flat (of if the investor believes the market is headed higher, he or she would place the spread at higher strikes).

Next week, we will discuss permutations that can be used on the typical butterfly spread that provides downside protection over a much larger range.