Monday, June 15, 2009

Butterfly Hedge IWM

A great way to hedge some long exposure going into expiration week is to buy a cheap OTM butterfly on a major liquid index. Usually you should expect to lose the entire premium if the trade does not work out because it is simply an insurance policy against your already delta positive portfolio. It reduces the cost of put protection and at the same time increases your potential risk/reward dramatically so you get more bang for your insurance buck.

I am looking at the IWM and the possibility of seeing a further selloff in the markets that COULD take the IWM to 49-50 by Friday's expiration. Butterflies profit most in the last week of expiration as the premium gets sucked out of the middle short strikes. I think if you are needing a hedge for this week the trade is to buy the June IWM put butterfly at 47/49/51 put strikes.

You can open this debit trade for 50 cents or better and the max gain of around 1.50 occurs if IWM is at 49 on Friday. Profit zone is anywhere between 47.50-50.50. So the probability of max gain occurring is rather low but thats how you get a potentially huge risk/reward where you could get a triple. Again this is a hedge trade that you should take only if you do not mind losing the premium paid.

No comments: