We Get Letters: Can a Butterfly Net a Bounce?

Regarding Monday’s Bonus Trade, reader Carl M. writes:

A May 50/55/60 call butterfly on GRMN at $0.60 or less leaves a very good potential profit range from 50.60 – 59.40. Any thoughts on that approach?

We intended this to be a purely directional trade, with room to run on the upside – but recognizing that there’s a good chance any rally the stock might see could be limited, the butterfly strategy has a lot going for it:

  • Maximum potential profit – on a percentage basis, more than 400% if the stock price is in the vicinity of $55 near expiration – handily beats the two spreads suggested in our original post;
  • It would be reasonable to expect at least a 100% return if the stock price is in the $50.60 to $59.40 range at expiration;
  • Because of the low cost, the risk in case of an unexpected plunge in the stock price is very low – as long as you don’t bite off a bigger position than your risk tolerance warrants;
  • Theta becomes positive when the stock is above $48 or $49, which is a significantly lower threshold than for the May 50/55 spread (a good thing), but slightly higher than for the May 55/June 50 diagonal.

All in all, this looks like it could be a good strategy…but you have to watch out for the upside risk. If GRMN is at or above $55 on April 29, a positive earnings surprise on the 30th, although unlikely, could push the stock up to $60+ and wipe out your gains, at least temporarily. So it might be a good idea to lock in profit (or at least a portion of it) on the 29th if the stock closes above $53 or $54.

Alternatively, you could add another May 60 call to the position. This would raise your break-even point at expiration to $51 or $52 and diminish your maximum theoretical profit; but you could still have a 100% profit if the stock is above about $50.40 the day before earnings, and you’d be biased to the up side if you want to bet that the news will be good (but your risk in case of a big gap down on bad news would be about 30% greater).

Of course, after today’s sell-off, which hit tech stocks especially hard, this discussion may be academic anyway. GRMN broke trend-line support in the first half-hour of trading and fell through our $43.75 stop-loss threshold shortly after noon. But the bump in volatility premium that accompanied the drop kept us in the trade, and although the official close was $43.73, we saw a buyer come in at the bell and push the price over $43.80. The last after-hours trade tonight was at $43.90.

So you might look at the pull-back as a golden opportunity to get in at a discount, or a warning to cut your losses and move on – depending on what happens tomorrow. (Not that it really matters, since we don’t suggest you bet any serious money on these bonus trades of ours. No way, no how. Nevertheless, we’ll be watching GRMN closely at tomorrow’s open.)


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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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