Monday, July 13, 2009

GS 1-3-2 Put Butterfly

Goldman Sachs (GS) is reporting earnings on Tuesday before the bell and it is widely expected to be a blowout report with huge profits. GS is without a doubt the best of breed in the financial sector and I never really like to bet against the best. However, in this case with everyone bullish I am looking to take a contrarian view into earnings.

GS implied volatility is up around 50% which is low compared to the past year but is an uptick from the last few weeks. GS has moved more than 11% on each of the last 3 earnings reports but the option marts are pricing in a smaller move this time around simply because the panic is gone.

I want to play the downside in GS with options but I don't want to just go out and buy puts straight up. I'm cheap so I want to finance any option purchase with an option sale. The put strike with the heaviest open interest is the 135 put so expiration could act as a magnet down to that area.

I am buying a 1-3-2 downside put butterfly using the 140/125/120 July put strikes.

Buy 1 GS 140 put
Sell 3 GS 125 puts
Buy 2 GS 120 puts

Net debit = 1.50 per butterfly

Confused? Don't be. This option trade as shown in the risk graph above gives you a fantastic risk/reward if GS were to trade lower into expiration day.

Max risk is the initial 1.50 you pay. This trade will lose that amount if by Friday GS is above 140. Breakeven at expiration in four days is 138.50. So GS needs to be below that mark for this trade to start making money.

Best case scenario is if GS trades 125 on Friday and this trade will be worth 13 bucks. Or roughly a 750% gain in a few days. Not too shabby eh? Infact this trade makes money anywhere below 138.50.

Of course the probability of GS being at 125 is slim, but if you think, like I do, that at least a 130 handle is possible by Friday then this is a great way to get into a cheap downside option play. This is a trade you should do with a small amount of capital because the odds are low but the potential payout is huge.


Anonymous said...

now that this trade is over

can you give us a example. if we made or lost money ?

Jason said...

like i said in the post, if it stays above 138.5, the play loses money.

if u cut losses that morning it wasnt that bad.

the better play in hindsight here was to sell an iron condor, as GS stayed fairly rangebound and the july options got crushed.