What If The Markets Crash Again?

“In the world of investing, there's an important distinction between insurance and hedging. Buying insurance is protection against the worst-case scenario. Hedging is buying some protection against a change in the market's weather.” - Howard Marks

Introduction:

With the recent market volatility, increasingly hawkish Fed, inflation, increasing interest rates, the war in Ukraine, never-seen-before level of financial action against Russia, the disturbances to logistics chains from first the pandemic and now the war...

There is no shortage for reasons for investors to be increasingly worried about the potential end of the epic bull-run we have had in the US markets ever since coming out of the Great Recession around 2010.

Most investors have long portfolios that will benefit from increasing prices... and when you look at monthly or yearly charts and concentrate on the long term, this is usually the best stance to take...

But even though we know that owning stocks (and buying them in discounts, like now) is the best thing to do long-term...

Times like this can be painful to sit through

High volatility can get on our nerves, and also makes our portfolio values melt (at least on the short term).

In this article, I'm presenting an interesting way to stay long during drawdowns and get paid for hedging in a clever "Option Investors Club" way.

How To: Get Paid For Hedging With 90% Probability Of Profit

First, to get this out of the way, hedging simply means "protecting your portfolio". Imagining that you're long tech stocks, times when tech stocks go down are bad for your portfolio value. Hedging this kind of portfolio would therefore mean "protecting against falling tech stock prices".

An easy way to do this could be to protect against negative price change in the Nasdaq index, or another suitable tech sector ETF unless you have a large enough account for protecting your AAPL position with a hedge in AAPL.

Suitable ETFs for "wider protection" could include...

• QQQ for the Nasdaq index

• ARKK for high growth stocks on ARKK lists

• SMH for semiconductor companies

• XLC for communication technology sector

• XLK for technology sector

And the list goes on.

For clarity's sake, however... For folks with accounts that can support it, protecting your exact positions with position-specific hedges is a good way to go about this. And this method can be used for any position where the asset you are invested in has options available.

Without further ado, let's take a look at the solution.

Introducing: Broken Wing Butterfly Spreads

In addition to having a funny name, the trade itself has very exceptional characteristics.

When you set it up, you can open it for debit or credit... and we always want to open the trade for credit, which means we are getting paid for setting up a powerful hedge.

A normal butterfly is set up as a combination of a short and a long vertical spread of an equal size.

In a Broken Wing Butterfly, the short vertical spread is wider than the long vertical spread, which allows us to get paid to open it.

Let's imagine a stock that is trading at $120 today, and we would like to hedge against a price drop for that stock.

What is a butterfly?

Example of a normal put butterfly:

• Buy 1 x $110 put

• Sell 2 x $100 put

• Buy 1 x $90 put

• All options have the same expiration

• Trade opened for debit

• Max profit width of strikes x $100 = $1,000

• Max loss equals opening debit

• Break even points between bought and sold options: width of spread - debit paid distance away from the bought strikes.

This creates a $10 wide butterfly where the max profit is received if the price is at $100 when the spread expires.

How do I break a wing?

A broken wing put butterfly (that acts as a hedge against a price drop) could be

• Buy 1 x $110 call

• Sell 2 x $100 call

• Buy 1 x $85 call

• All options have the same expiration

• Open the trade for credit

• Max profit = width of the debit spread + opening credit = $110 - $100 + opening credit = $10 + opening credit

• Max loss = difference of "wing length" - opening credit = ($100 - $85) - ($110 - $100) - opening credit = $5 - opening credit

• Break-even at sold strike - width of debit spread - credit received (for puts, and inverse for calls... so essentially beyond the sold strikes)

That may look a bit complicated the first time, and it actually is. ;)

But if you imagine that we can get $0.20 to open this trade, the max profit would become $10.20 and the max loss $4.80, so there you have the final numbers. (And since one US stock option controls 100 shares, you would then multiply all the numbers by 100, so $20 credit per spread with $480 risk and $1,020 max reward.)

The break-even point would be at $100 - $10 - $0.20 = $99.8.

And so, the opening credit is 4.16% of the total risk while max profit vs max risk ratio is 2.125. Quite solid multipliers.

How the trade works

If we have opened the $110 - $100 - $85 broken win put butterfly for $20 credit, here's the main scenarios

• Price goes up = keep the credit (4.16% ROI for you, yay!)

• Price goes nowhere = keep the credit (4.16% ROI)

• Price goes down but does not reach the long put at 110 = like above, 4.16% ROI for you. Congrats!

• Price goes between $110 and $89.80 (upper wing and break-even) = positive return, up to +212.5% ROI

• Price goes below break-even point and lower wing and stays there until expiration = you lose something between 0 and $4.80

• Price below lower wing at expiration = max loss

Not half bad... but maybe a bit difficult to grasp without a visual.

A real trade example

Here's an example trade on QQQ for reference. The prices are different but the principle is the same.

For this one

• Max profit = $720

• Max risk = $580

• Opening credit = $20

• Probability of Profit = 90%

• Break-even at $322.80, anywhere above is profitable

• Small win = $20/$580 = 3.4% ROI (in 21 days) anywhere above $337

• Big win up to $720/$580 = 124% ROI at $330

If somebody would only trade these, once every 3 weeks, they would have a CAGR of over 76.5% if all they ever got was those small wins. That's damn solid if you ask me!

But while it's really solid, I would not recommend anybody to do (only) this. Like said, this is a great way to hedge a portfolio. The point was not to make this the whole portfolio!

Why did I place the QQQ broken wing butterfly there?

If you look at this image again, you'll quickly notice that $330 is slightly above the previous low and the break-even point is more or less at the previous lows.

Getting real

After writing the article, I opened this trade on my portfolio, and my real opening credit was $0.17 per share, or $17 per option.

• From the $17, I paid $0.534 trading fees and $4 commissions, so the real world credit was just $12.466.

• Real risk on the trade with fees included is $587.534

• The real-world "small win" ROI becomes $12.466 / $ 587.534 = 2.12% in 3 weeks.

• CAGR drops to 42.89% and while that's still really nice, it's not the theoretical 76.5% written above. (It's still worth doing, however: who would not want to hedge for credit and 90% probability of profit when you know how to do it?)

So what, what's the point?

Theoretical calculations are theoretical. Real ROI and CAGR calculations should always include your real cost basis.

What to do if price drops below the sold puts?

If the price drops slightly below and does not go lower, just keep on holding. Close to sold strikes is where you get max profit, so strong nerves = strong gains.

If the break-even point is challenged, however, you could

• Close for profit and open a new one (this is the simplest way for people who are not intimately familiar with options: do this if you're not sure about what you're doing!)

• Roll "further out" to buy more time if you think price will eventually climb back up

• Close long puts to cash in, roll the short puts and potentially protect them by setting up new spreads

• Some even more creative option tricks that some folks can come up with depending on situation

If you want to see how I manage this trade, sign up for those updates I mentioned just above. ;)

Some further points to consider on big gaps down

While protecting specific stock positions, bad news could throw the price below the whole butterfly and give you a max loss risk without the possibility to close for profit early. Keep this in mind when considering using broken wing butterflies.

When playing index and sector ETFs or other bigger baskets, the risk of this kind of super fast flash crash event is much lower and as for example in the real QQQ example above, there's 10% buffer between the current price and the butterfly body, the risk of a gap below the whole option spread is negligible.

I personally like using these trades on highly liquid and quite "lazy-moving" index ETFs for also this reason.

Is it possible to do the same with calls?

Absolutely. You could even do that at the same time to create a "guaranteed win" in between butterflies and higher profit areas for example 10% below and 10% above current prices. (By placing the butterfly bodies at +/- 10% and breaking the wings that are further away from the current price.)

And then simply either watch the account grow or get ready to close for profit early if price goes up or down a bit too fast.

A call broken wing butterfly has a long vertical call spread closer to current prices and a wider short vertical call spread further away from current prices. Open for credit, break even above sold strikes, profitable anywhere below the break-even point and so on.

How to set these up for real?

Watch this video for a 3-minute-demo on how to set up this broken wing butterfly spread and how to tweak it to suit your portfolio.

What if I want to learn more?

Go to this page to get my book "Guide To Hedging With Broken Wing Butterfly Spreads" for free when you try our Reversal Catcher Strategy. (It's a strategy for identifying great times to set up these trades... and much more!)