Updated: May 25
When you have reasons to believe that there is a bigger probability for the market not to move (in the time frame you are aiming), while the market implied volatilities suggest that there is a higher probability for a move to happen, you could translate that belief into a trade that will profit if the market will stay quite.
A common strategy that traders use for that is the butterfly, which pays maximum amount (capped) if the market stays at the middle strike, and lose the premium paid for the butterfly if the market ends up outside the other two strikes.
For example, let's assume that our model predicts that there is a higher probability for the market to stay between -1.5% % +1.5% than from the probabilities that the options implied volatility is telling us. In that case we can buy 10 call 405, sell 20 call 415 and buy 10 call 425.
(* The model probabilities are in orange, while the market implied probabilities are in blue. So, the edge is to bet on a stable market. (Example is taken from the SqueezeMetrics model).
We paid 3.7K and the maximum profit will be 6.3K (total payback of 10K) if the market ends next Friday exactly at 415. (1 : 1.7 R:R ratio). If it ends under 405 or above 425, we will lose all the premium paid. However, this is the maximum risk that we are taking. And anywhere between the strikes we still get some payoff, depending on where it lends.
Here is a P&L chart (if we paid 4.5K for the butterfly):
And so, as nothing happed in the Spy today, the butterfly is starting to harvest the time decay.
If at any time, during next week, we change our mind about the edge we think we have in this position, we can close it immediately, and move on to other trades.
Market up 1%. Gave some profit back.
Market is down -0.25%. Buying P209 & C221 for a total of 1100$. Locking-in a payback of 4K$ at minimum, thus taking most of the risk out (still risking 800$). Now the R:R looks even better.
The following trade frame is an example for educational purpose only.
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