How do you trade downside, while still not losing much if the underlying continues to go up?
This is a question I am often asked by many. There isn’t any better instrument than options, that I know of, to trade such a scenario. Albeit, the answer actually depends on how much do you understand options.
In this post, I will take an example of Russell 2000 (Ticker : RUT) using real-time prices (as of this writing)-
Our hypothetical scenario (not what I think) : I think RUT is done going up, but I can’t be sure. There were many times when I thought this will happen but it didn’t, resulting in loss of my trade and capital. On the other side, there is high likelihood that it will drop. Based on my best estimates, I think it will touch 200dma, in 3-6wks, which is around 1150. So what can I do? Well there are many way to trade this scenario, but one of the scenario, I am going to use is utilizing BUTTERFLY SPREAD.
Here is how –
- Buy to open RUT Weekly Feb2 Put 1150
- Sell to Open 2 RUT Weekly Feb2 Put 1130 and
- Buy to Open RUT Weekly Feb2 Put 1100
Such a trade can be done for $0.15 credit (as of this writing) and requires $2,985 margin by thinkorswim. It has 30days life time. If RUT doesn’t drop and stays above 1,110, this will be profitable. It will be, however, hugey profitable if RUT is at 1130 at expiration by generating over $2,000 profits. However, it is low probability event.
Here is how the risk/reward curve looks like-
So, it makes a little bit of money if RUT stays above or rallies to the moon, it makes lot of money if RUT is at the short strike and it will lose is RUT drops below 1110, a 76 points drop below where it is as of this writing.
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All in all, it looks like a good strategy, so what’s the catch?
As with any other strategy, there is always risk. And the risk here is a sharp drop in a short period of time much before expiration. Thus risk & trade management is of high importance. Placing a trade is easier then closing a challenging trade. How you manage the trade is again going to be based on your trading skills but there are plenty of ways. Read more about BUTTERFLY SPREAD.
Should you have any questions about options or on how to trade options profitably, feel free to contact at Ask@OptionPundit.com and I shall be glad to answer your questions.
Trade carefully, trade profitably, OP