Question: How can you ride the huge bullish trends in metals, while avoiding the often sharp and deep reversals?
Answer: Initiate an unbalanced broken wing butterfly.
There is a saying that trading is simple, but it is not easy. Another cliché that happens to work in markets is, "The trend is your friend." All a disciplined trader needs to do is unemotionally follow the trend and apply good risk management, and he will succeed. However, the longer a trend continues, the more nerve-racking it can be to hold a position. When a trade moves against you, it is natural to ask, "Am I buying the top?" or, "Am I selling the bottom?" Even the most seasoned trader can become fearful at the first sign of a pullback. A trend is just that — a trend. It is seldom a straight line. Even if you find a trend that is going in the right direction, you still could get in at the wrong time, and they all end at some point.
Imagine getting long the silver exchange trade fund SLV in late December or early January only to watch it fall 13% in a month (See "Timing is everything"). Naturally, you would think that you had bought the top. Disciplined traders rarely are willing to risk 13% of their capital in a trade. Most would be stopped out only to watch the market continue higher. This is frustrating and not uncommon, especially in the volatile metals sector that has experienced huge moves and often sharp corrections.
Few traders can ride a bull or bear market position when the first sign of a reversal occurs, especially if they were tardy on the initial trend. We all can get spooked out as fear of losing can be a stronger emotion than the greed of riding a winner. Strong risk management allows you to stay in potentially profitable positions while protecting your downside. This can be accomplished through strategic options positions that can weather an economic tsunami in the wrong direction.
Getting into a bullish position at the wrong time can squeeze a trader out of a position right before a strong move occurs. It is a good time to employ a derivative of the broken wing butterfly (BWB). We call it an "unbalanced BWB."
If constructed correctly, this strategy entails no risk should the trend in the underlying reverse or flatten out.
We will construct this position in SLV based on the late March price of $35.25 with 56 days until expiration and implied volatility of 39.4%. We construct a BWB at a cost of 69¢ or $690 on a 10-lot by buying 10 $36 calls at a cost of $2,280, selling 20 $40 calls collecting $1,800 in premium and buying 10 $46 calls at a cost of $210. We then add an out-of-the-money short vertical call spread by selling an additional 10 $40 calls and buying an additional 10 $46 calls. The vertical spreads bring in $690, covering the cost of the BWB, not including commissions. We now have a position that was placed for a $0 debit, so if the market stays flat or sells off, we still will break even.
A P&L graph of this trade illustrates the conservative nature of this strategy and can be found online. Statistically, this trade is excellent; we know that we will break even or make money 95.45% of the time (+/- 2 sigma move).
The maximum profit area of the trade is our short center strike, or $40. Since it is just outside the +1 sigma band, we have a very good chance of the underlying reaching $39.20. Even if you are unfortunate enough to get caught in a temporary pullback on expiration, you still will be able to rest easy because the strategy will break even from $36 per share all the way down to $0.
The unbalanced BWB provides everything an aggressive trader could want: It creates a long position that allows you to hop onto the trend right away; the first long strike is in-the-money, so profit (at expiration) is built into the trade, and the position makes money even if the stock remains stagnant until expiration.
The strategy can be implemented in a bullish and/or a bearish fashion, or traders can place the trade simultaneously in both directions. Most importantly, should the stock reverse its current direction, there is zero financial risk.
In short, we are hard pressed to find a better trade for a strong trending market — we have room for profit potential and downside protection.
Continue to the next page for a P&L and schematic of this trade…
Susan Steward is chief economist at Random Walk Trading.com. Random Walk is staffed with ex-floor traders and current fund managers. Check out randomwalktrading.com free educational material.