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How Out-of-the-Money Butterfly Spreads Create Profits Trading SPX

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The OTM butterfly spread benefits from the passage of time and won't be as exposed to a comeuppance in volatility.

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Editor's Note: JW Jones offers more content at OptionsTradingSignals.com.

Over the past few weeks the broad stock market has seemingly grown increasingly more bullish. Market pundits, traders, and even high-profile money managers are stating publicly that the easy trade over the next few years will simply be being long, high-quality stocks. While time may prove these managers wise, it's likely a bit early to be that bullish.

As traders, our job is to create profits consistently regardless of price action. The best traders are masters of blocking out the noise and emotion, and letting various forms of data guide their decision-making. At this point in time the bulls have the bears pushed against key resistance at the SPX 1150 area. However, the bears have their eyes set on the 1130 level and from there the key SPX 1040 support area.

If the S&P 500 breaks out over the 1150 area with strong volume we could move higher to test recent highs; however, if the 1040 area were to give way to the bears the bullish parade would end. At this point in time, it's too early to tell which side is going to win this battle. The monthly chart of SPX tells the entire story.


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Until proven otherwise, my bias is to the downside. What might surprise most readers is the reasoning behind my thinking. My expectation of lower prices has nothing to do with macro economic conditions, it has nothing to do with unprecedented intervention that we've witnessed by the United States federal government, and it has nothing to do with housing numbers. The reasoning behind potentially lower prices is simple: defined risk. The SPX chart above and even the daily chart listed below are both indicative that the SPX 1150 area is a critical psychological level for market participants. We're literally at a precipice right here, right now.


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When major resistance or support is very near the current spot price of any underlying, typically low risk/reward setups can be found. After spinning through several ideas and option strategies, an out-of-the-money (OTM) butterfly spread seemingly made a lot of sense. The OTM butterfly spread would benefit from the passage of time and wouldn't be as exposed to a comeuppance in volatility. This strategy could produce a great potential return for a defined amount of risk.

After some brief analysis, the best proxy was using the Spider ETF SPY as opposed to the SPX index. The bid/ask spreads are quite wide on SPX at times, particularly when volatility is rising. Consequently, it can be arduous to get decent fills from the SPX market makers in rapidly moving market conditions, which seem to be the norm recently. Besides the normal option expiration on monthly or quarterly basis, options that expire every week have grown in popularity recently. A primary reason why volumes have exploded is due to the weekly expirations routine offering of unbelievable risk/reward setups, particularly through the utilization of Theta (time) decay trading setups.

After running through various expiration dates, it made sense to utilize the October weekly options that expire on Friday, October 8. Since I have a bias to the downside, I used an OTM put butterfly. Traditional butterflies are typically written where the current price is straddled by the wings of the butterfly spread. In an OTM butterfly, an option trader places the entire position out of the money. It helps reduce the cost of the butterfly, and because the option contracts are out of the money, they're not impacted as harshly by rising volatility. In addition, these OTM butterflies usually have very attractive risk/reward characteristics.

SPY was trading around $114.13/share at the close on Thursday, so the OTM butterfly I constructed had the following strikes: Long 1 OCT WKLY. SPY 108 Put / Short 2 OCT WKLY. SPY 111 Puts / Long 1 OCT WKLY. SPY 114 Put. Here's a snapshot of the SPY October weekly option chain as of the close Thursday:


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No positions in stocks mentioned.
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