Kaeppel's Corner: The Butterfly Rising Method

Jay Kaeppel, Optionetics.com
January 18, 2011

There are a lot of ways to “play the game.” In a nutshell, there is long-term buy and hold investing, there is high frequency trading, and there is everything in between. We can trade stocks, options, LEAPS, futures, ETFs, ETNs, FOREX, warrants, and so on and so forth. So nowadays a person has to give some serious thought as to what approach or approaches to investing best suits their own personality. And it can be a fairly cumbersome task.

Still, deep down, let’s face it, we all share the desire to make as much money from our investments as we possibly can. The conundrum is that investing for “maximum profit” typically entails above average (or more accurately, far above average) risk. Fortunately, there are ways to “take a shot” without “betting the ranch.” The objective is to enter into a position that has the potential (and ideally a better than even likelihood) to make a good return, without risking a lot of money. This week’s piece will highlight one such set of steps for option traders.

Steps for The Butterfly Rising Method

I am going to detail one approach to speculation this week that I refer to as “Butterfly Rising” (OK, so I like to channel my inner David Carradine once in awhile, is that such a crime?). I make no claim that it is the one best and only way to succeed and there are no “you can’t lose” promises being made. The steps presented serve merely as one example of a way to attempt to put the odds in your favor.

In a nutshell, we are going to look for stocks that have active option volume and which appear to be in an uptrend. We will then look at a little know strategy known as the out-of-the-money (OTM) butterfly to look for trades with good upside potential but not a great deal of dollar risk. I will be using Optionetics Platinum software to execute these steps.

Step 1: Filter Option Volume

For this task I will use the “Stock List Filter” routine and find only those stocks whose options have relatively tight bid/ask spreads (See Figure 1)

Figure 1- Filtering options for tight bid/ask spreads

We then save those stocks to a list and proceed to Step 2.

Step 2: Find the Strongest Trending Stocks

In Step 2 we start with the list of stocks we created in Step 1. There are many ways to designate a stock or group of stocks as “the strongest trending.” The method that we will use here is the “ChannelFinder” routine within Optionetics Platinum software. See Figure 2.

Figure 2 – ChannelFinder Input Screen

ChannelFinder essentially measures the slope of the regression channel for each security under examination (are we having fun yet?). We will save the 100 strongest trending stocks as calculated by ChannelFinder.

Figure 3 displays the stock with the strong Channel ranking at the time this test was run.

Figure 3 – Strongly rising regression channel; this stock is designated as “rising strongly”

Step 3: Run OTM Butterfly Finder

An out-of-the-money butterfly spread is a foreign concept to about 99% of all investors. Maybe that’s part of the reason I like it so much. As we will use it here, it involves:

-Buying a call option with a strike price above the current price of the stock

-Selling another call option with a higher strike price

-Buying a third call option with an even higher strike price

For our purposes this trade is done in a ratio of 2 x 3 x 1 (i.e., buy 2 calls, sell 3 higher strike price calls and buy 1 higher strike price call). Figure 4 displays the OTM Butterfly Input screen.

Figure 4 – OTM Butterfly Input Screen

Figure 5 displays the top trade in the output list.

Figure 5 – OTM Butterfly Output Screen

This trade involves using options on stock ticker HES as follows:

-Buying 2 Feb 75 HES calls @ 3.20

-Selling 3 Feb 85 HES calls @ 0.40

-Buying 1 Feb 95 HES call @ 0.12

-The total cost to enter this trade is $532

-The maximum profit potential is $1,468

-The breakeven price for HES stock is 77.66 (as of 12/20/10 when this position was entered the stock was trading at $74.60)

Figure 6 displays the risk curves for this trade.

Figure 6 – Risk Curves for HES OTM Butterfly as of entry date (12/20/10)

Lastly, Figure 7 shows the status of this position as of 1/14/2011.

Figure 7 – Risk Curves for HES OTM Butterfly as of 1/14/11

Summary

The position highlighted in this piece using options on HES has doubled in value in less than a month on a 10% advance in the stock price (from $74.60 to 82 and change). So does this mean that we’ve discovered the “holy grail?” Hardly. Still, it does highlight the possibilities. More importantly, this example highlights a relatively simple process for finding potentially low-risk/high reward opportunities.

Now go forth, Grasshopper.

Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”

Optionetics.com ~ You’re Options Education Site