Nothing like a few bank failures to stoke investors' fears. But if those fears have mostly subsided, how can we set up an option trade to profit? Here is a broken-wing butterfly on the VIX with little money at risk to the upside if the VIX should spike again.
Bank Failures Cause A Spike In The VIX
The CBOE Volatility Index is often referred to as "the VIX" or the fear index. It measures the implied volatility of the S&P 500 index. A higher reading on the VIX means more price movement is expected in the next 30 days but it doesn't specify what direction.
The VIX recently spiked to 31 after bank failures threw the financial sector into a tailspin. But as is often the case, once the fears subsided, the VIX dropped back down to 19.
We can set up an option trade that will profit if the VIX finishes between 17 and 19 on May 16. It's called the broken-wing butterfly.
Broken-Wing Butterfly Option Trade
We'll use puts to set up this trade but unlike a regular butterfly option trade, the "wings" won't be an equal distance from the short strike.
With the broken-wing butterfly we leave a larger gap on a particular side. This results in less risk on one side and more risk on the opposite side.
To set up the trade using the VIX, we can do the following:
- Buy 1 May 16 put with a 16 strike price @ 5 cents
- Sell 2 May 16 puts with an 18 strike @ 40 cents
- Buy 1 May 16 put at a 19 strike @ 80 cents
Notice that the put option with the upper strike price is one point away from the middle puts while the lower strike price is two points away from the middle puts. That uneven difference is what makes it a broken-wing butterfly. The risk will be minimal on the upside but larger on the downside.
Risk Vs. Reward
The put at the highest strike of 19 costs 80 cents and that is offset by the credit brought in by the two puts at 18. That leaves the entire spread at a net debit of just 5 cents. Multiply that by 100 and each spread will cost you a minimal $5.
The $5 cost is also the most that you can lose on the trade to the upside, excluding commissions and fees. If the VIX finishes at 19 or higher on May 16, all the options expire worthless and you have a minimal loss.
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What if the VIX goes lower? Calculate the maximum risk to the downside by taking the width between the middle puts and the put at the upper strike. That's just one point. Add the premium paid and it gives you your downside risk of $105.
Notably, the maximum loss is for a finish at 16 or lower for the VIX on the expiration date. The VIX hasn't been that low since November 2021.
A Switch From Adding To Subtracting Premium
On the profit side, instead of adding the premium, you subtract it from the difference between the middle puts and the upper strike. That makes the maximum profit $95.
Meanwhile, the trade hits its maximum profit if it closes at the strike of the short puts at 18.
Please remember that options are risky and investors can lose 100% of their investment.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
