Butterfly Spread for the Range...

I am as about as anxious as I have ever been in the market. Funny, we have a correction underway, I am short, and I am anxious. Very bizarre.

I say correction, and I mean it. We have seen the SPX correct 5% in three days. I would not be surprised to see another 5%-10% in the coming week. Assuming that the correction is eventually met with buying support, the SPX may very well trade in the 960-1040 range for a while post correction. If that is the case, how do we profit in this environment? I currently have short SPY puts at 104 which if assigned will wipe my short SPY equities position out this month. I will see a small loss from that assignment, but I will not complain. I was early and deserve to pay the tuition on that one. However, is there a way that I can make up those losses with limited risk going forward? I think so. Check out the risk graph that I put together for the SPY:



This graph is of course a traditional butterfly spread. I built it using put option spreads on the SPY with March expiration's. I could have also done it with call spreads, but since I am currently short a decent number of March 101 puts I decided to build on that position.

For those unfamiliar with this type of spread, it is formed by selling short two (2)puts at a middle strike price while simultaneously buying one (1) long put at some strike higher and one (1) long put a some price lower. The exact number of contracts is up to you but the ratio needs to be 2:1 (two middle shorts, 1 long above, 1 long below)

For my spread I chose SPY 101 as the middle short, 106 for my top long put, and 96 for my bottom long put. The total cost of this transaction for me is $3.07 and that is the maximum that I can lose. (My cost is about $0.40 higher than it would normally be because I am using pre-exising short puts sold at a lower premium than they are being traded at today). This max loss point occurs if SPY closes below $91or above $111 on March 20th. For this to happen, either the correction needs to run very deep without finding support - which means we have more than a correction - or the market rallies again - which is hard for me to believe.

My profit will range with this spread if spy is between $94 and $108 by March expiration. Any close of the SPX in the 140 point range of 940 to 1080 will produce profit for me in March. The maximum profit potential is $6.93 if March closes with the SPX at 1010. The fall off in profits from this middle max is linear in both directions (SPX above 1010 or below 1010). I would double my money if the SPX closes between 970 and 1050. I think it is a good risk reward profile.

I am contemplating the same for DIA. We have seen the DJI correct a similar 5% in three days with the real possibility of 5% to 10% more. That would put the DJI down in the 9000-9600 range while it finds support.

Here is that risk graph I am considering:



For my spread I chose DIA 96 as the middle short, 106 for my top long put, and 86 for my bottom long put. The total cost of this transaction for me is $3.67 and that is the maximum that I can lose. (My cost is about $0.40 higher than it would normally be because I am using pre-exising short puts sold at a lower premium than they are being traded at today). This max loss point occurs if DIA closes below $86or above $106 on March 20th.

My profit range with this spread is $89.50 to $102.50. Any close of the DJI in the 1300 point range of 8950 to 10250 will produce profit for me in March. The maximum profit potential is $6.33 per share if March closes with the DJI at 9600. The fall off in profits from this middle max is linear in both directions (DJI above 9600 or below 9600). I would more than double my money if the DJI closes between 9350 and 9850.

Let me know what you think of the ranges - I think they are correct.

Cheers.