By Chris Hausman, CMT, Swan Global Investments Portfolio and Chief Technical Strategist
“Stay near me – do not take flight! A little longer stay in sight! Much converse do I find in thee… Float near me; do not yet depart!” William Wordsworth’s words in “To a Butterfly” (1801) can be aptly applied to traders and portfolio managers alike when speaking of option butterflies. Can this option structure be used for more than just speculative purposes? For savvy traders and portfolio managers it can be used as a replacement for more traditional hedging vehicles.
One of the most basic structures to protect a portfolio involves the use of a collar. This strategy purchases a downside put with a strike price below the underlying price and then attempts to “fund,” or reduce the cost of the put by selling a call with a strike price above the underlying price. Collars have been popular strategies for portfolio managers because they offer absolute protection to the downside beyond the put’s strike price. It also allows some upside participation up to the short call strike.
Below is a basic example using the most liquid option ETF, the SPDR S&P 500 ETF Trust (SPY). The mock portfolio involves the purchase of 100 shares of SPY at $219.09, the purchase of the September expiration 208 strike put at $0.66 and the sale of the September 230 call at $0.07. This is a standard 5% out-of-the money put/call collar. As you can see, this particular example must be paid for. In other words, the put-call collar must be purchased for $0.59.
SPY SEP 208-230 Collar Profit and Loss Graph
Over the years, downside protection has become increasingly more expensive because of an option phenomena known as skew. Skew measures the difference between the volatility of downside strikes versus upside strikes. Since there is a natural demand for portfolio protection, the price of downside struck options are more expensive than a corresponding (equal % distance from spot price) upside struck option. As the skew changes, this form of absolute protection may become cost prohibitive for a portfolio manager seeking a certain type of risk/reward ratio. In addition, the cap on potential upside profit may not be an attractive feature of this structure.
So are there any alternatives that may provide protection, especially if a portfolio manager wants to protect a certain “zone” and not sacrifice the entire amount of upside participation?
Options offer just that – options. There are a myriad of strikes, expirations, and cross-asset option allocations that can be used. Only your lack of imagination will limit you in constructing the proper hedging vehicle. The popularity of different option strategies drift in and out of favor. Applying esoteric names to “new” strategies is usually a marketing ploy using tried and true spreads with an unproven “twist.”
One strategy that has remained a staple in the arsenal of traders and portfolio managers is known as the butterfly. The basic butterfly involves three strikes (head, body, tail) with the same expiry and on the same underlying.
The butterfly offers a lower cost way to protect areas of a portfolio with minimal adverse impact to performance if they do not expand. They do not attempt to provide absolute protection beyond some price point like the collar, but can be used tactically to insulate a portfolio in a zone without limiting the upside potential of a long equity portfolio. Below is an example of the SPY Sep 204-208-212 Put Butterfly. The trade would be constructed by purchasing 1 Sep 204 put, selling 2 Sep 208 puts, and buying 1 Sep 212 put and paying $0.18 for the entire structure. A quick way to remember the basic construction is to “Buy the wings and sell the middles.” The basic fly has strikes that are equidistant.
This example below selected the 208 strike as the middle strike – the exact same strike of the put in the collar example. This butterfly is known as a 4-point fly because the maximum value at expiration is exactly 4 points. If the price of the underlying is at or near the middle short strikes at expiration the butterfly will expand and move towards maximum value. For example, our Sep 204-208-212 put butterfly could potentially expire at maximum value of $400, providing a $382 profit (max value-fly cost).
SPY SEP 204-208-212 Put Butterfly Profit and Loss Graph