Selling Puts or The Bullish Butterfly

I have been hearing a lot of chatter about shorting puts. I have heard highly regarded traders talk about the strategy on beaten down stocks including some Dow components under the assumption that the bottom has been reached. With implied volatility (IV) at record highs why not sell premium, they may say, on stocks such as GE.

Look at the chart below. I have included the price action the 200 and the 50 day moving averages and the implied volatilities (right axis). IV well over 100% is certainly a record high for a blue chip, Dow component such as GE. The stock price hits new lows at just below $6 well below the moving averages but the stock shows signs of life after forming a candlestick reversal pattern. Now if the point of owning stocks is to buy low sell high why not buy GE when the reversal seems to be in place? Better yet why not sell puts?!

By selling puts you bring some premium so long as the stock remains above the strike price but if it falls below the strike close to expiration you may get assigned. Therefore you must have sufficient cash in your portfolio in the eventuality that you are assigned. Think of it this way how many shares of stock are you willing to own if you are assigned every short put that you sell short. Let’s say that I have a $50,000 and I am willing to put about 10% of my capital on GE at $7.5. That is $5250 or about 700 shares. You can then wisely sell 7 March puts at $0.72 to bring in $504 in premium into your account.

How about your risk? good question. The theoretical risk is the same as the risk you would acquire by buying the stock minus the premium you brought in. That is $5250 - $504 = $4746 of course the commissions are already gone. If GE was to fall to zero overnight you will lose $4746. OK you can argue that that is not going to happen fine. But the fact is that your Max Profit/Max Risk is about 11%. Yet professionals (floor traders) do this all the time. We mere mortals have to think of the effectiveness of our trading. Even if our buying power is reduced by a fraction of that capital at risk do we really want to play this game?

The whole point of options is leverage and risk management at least in my mind. What you are doing with this trade is the exact opposite as we remove all leverage and risk management in favor of the probability of expiring. But because the reward is so small you could not do this profitably unless you do many of these trades. Eventually that “Black Swan” will happen and you can lose a great deal of money. In fact the Black Swan has already happen hasn’t it? The markets have lost over 50% since the peak of October 2007.

I suggest a smarter way to take advantage of the high implied volatility in stocks that have been beaten down that have historically high IV and that are likely to bounce. However, let us risk small to profit big instead of risking big to profit small. Enter the bullish butterfly.

Following the same historical example of GE at that apparent short-term bottom suppose we enter a butterfly just above the market. This time we will risk about 1% of our $50,000 account or $540 to make up to $1959.92 or 363% return on capital, which in this case is the same as the return on risk.

You may say that it is a long shot but the philosophy is not much different than that of the short put: you are expecting a small to moderate move up by March expiration. However in the worst case scenario you will lose $540 in the case of the butterfly but potentially a great deal of capital in the case of the short put. I grant you that the break even point in the case of the put is much lower at $6.78 compared to the $8.04 for the butterfly. WIth the stock at $7.41 either one could happen very quickly.


But what if the stock does go up significantly? Well here is what actually happened since I was merely back testing these strategies side by side:

As of Friday one week to expiration the butterfly has yielded a profit of $1090 well over 2x the profit in the short put $462. Needless to say that having 2x the profit for 1/10th the risk is my kind of trade.

The issue here is that the retail public has an advantage over the floor trader: we KNOW technical analysis. We spend countless hours studying patterns learning techniques such as candlestick patterns etc. The professional trader focuses on IV selling expensive options and trading with the greatest probability of expiring based on the Black-Scholes or other option pricing model. We retailers have a different background.

You may say that this retrospective analysis is all fine but now that the bounce has occurred the opportunity to either sell puts or buying bullish butterflies is probably gone. My response to you is prepare for the next opportunity to come in the next few weeks. Here is why: There is no bottom until there is a retest of the lows. A retest does not mean necessarily that the markets will go down to the previous lows or break below them. No, it just needs to go down to make a higher low. But even if the markets DO go down and make a new low there will be some stocks that will make a higher low at a time when the indices may be making new lows. In either case even as the markets rally strongly as they have over the last few days the test of the lows will occur soon and that would be a great time to go bottom fishing for those opportunities.

We can certainly pick the (formerly) blue chips of the DOW but take a look at fundamentally sound companies that have been reaching 52 week lows recently. Here are some that I would consider right now close to their 52 week lows and have liquid options:

TAP RTN COP GD RIMM LMT DO NOC K TM SLB UPL FDX ISRG BNI BA UNP ECA UTX HNZ PG SIAL APA MCD PEP COST RIG CL KMB BAX GENZ UPS TD EOG.

Remember the secret is to locate among these the ones that make a higher low when the market indices make either a new low a double bottom or a higher low. Use the Candlestick reversal patterns to identify the reversal points thus getting in early.

But why bottom fish when you can follow the very same approach with companies that are exceeding their 200dMA in recent days? Yes there are such companies and they would be good candidates as they have defied the trend in search of new highs. Here is a list:

MYGN FDO ESI ORLY AZO HANS NFLX GOLD AAP DLTR WYE DNA APOL ROH GVA AMZN CERN TEVA ILMN.

This list is rough and requires that you be selective. The idea is to risk small to profit big. Be sure that you can enter the trade without concern of losing all the capital in the trade, and let time do its trick.

In my opinion the best features of options are leverage and risk management. Retail traders have the advantage over professionals of a deeper knowledge of technical analysis and a more analytical approach to the selection of candidate stocks. Take advantage of that!