After the FED inspired exuberance in the last half of the month of December, I felt I should get a little short.
To act on this, I entered an Unbalanced Broken wing Butterfly in Russell 2000 index options (RUT).
This is a way for me to short RUT with some upside protection. For February 20 expiration, I bought one 1250 call, sold 3 1270 calls, and bought 2 1350 calls to define my risk. The short calls are sold at about 5% higher than where RUT is trading currently. The spread was sold for a net credit of $10.15.
I sold the spread for a pretty nice credit, but 50 days to expiration is pretty far away. I think that it is in the realm of possibility that RUT could very well move up that 5% before expiration.
One of the reasons that I like Broken Wing Butterflies, and more particularly the unbalanced kind, is that if I'm wrong, and RUT expires at the 1270 strike, the net credit on expiration will be in the neighborhood of $25.00. This far exceeds my income expectation on this trade and would be a bonus. The worst case scenario for this structure is if RUT runs up 5% very quickly in the new year. The expiration break even is 1285 for this particular butterfly, and if that level is touched, I will close the trade.
Ok, so looking at the P&L chart above, it could cost as much as $32.00 to close the Unbalanced Broken wing Butterfly at 1285 before expiration. This is more risk than I am willing to bear. Enter the hedge: An out of the money butterfly in RUT.
I spent quite a while trying to find call debit spread structures in IWM, the Russell 2000 ETF, that satisfied the purpose of a hedge, and I couldn't find one. I was initially wanting to use IWM, because if I came up with a structure that used the same strikes as the trade above, I would still be able to enter. What I ended up settling for as my hedge is the 1260/1280/1300 call butterfly expiring in February monthly cycle. If my short term negative opinion on RUT doesn't play out I am going to buy 2 butterflies to hedge my UBWB. If RUT blasts off 5% these butterflies will allow me to close at 1285 with much lower losses than I other wise would be able to.
So, here's the skinny. If RUT is weak when it opens on the 2nd of January, I will just close the UBWB if I can close at $4.85 or better. If not, I will buy the OTM Butterfly hedge, and I will be in the trade for the long haul. The UBWB is a negative delta trade that benefits most when RUT declines. The double edge on that sword is that the UBWB can go far in the red very quickly to the upside. The purpose of the hedge is to nullify that delta somewhat without giving up the income side of the trade.
If you have any questions or comments, don't hesitate to ask in a comment below.
I will update the status of the trade here periodically. Follow me on Twitter @B50cal1978 as I post updates there as well. Don't be afraid to check out my sponsors below and to the right.
Wishing all of you and your families the best in the New Year!
STT
Update: I was able to close the Unbalanced Broken wing butterfly for 4.85. This results in a profit of $5.30. I did not buy the hedge. I was lucky to get 3 down days in a row. The negative delta was high enough that a decline of 2.5% in the index was all that I needed to hit the profit target.
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