Wednesday, September 28, 2005

Chasing Flies

I'm trying to work into the Oct 117/120/123 SPY butterfly for a credit between 0.20 to a 0.50. I started today by shorting the 120 calls for 2.85. This put me into a bearish position in the SPY with potentially unlimited upside risk. (Being short an in-the-money call is pretty close to the same as being short stock when the stock moves up.) In order to establish the position for a credit I need to buy the 117/123 call wings for less than 5.70 (2.85*2). I was prepared for this to take several days, if I am able to even pull it off at all. During that time I am exposed to the upside risk. If the fly gets completed for a credit it will be a nearly risk-free trade at that point. So that's the goal.

Now today it seemed like the market had quite a wide intra-day swing. After I shorted the 120 calls the market dropped quite a bit. At several points today, I could have completed the fly for free or a 0.05 credit easily. The question in my mind is should I have? I feel bearish about the market and think that I have a good chance of of buying those wings cheap enough to get into the fly for a good-sized credit.. This would then give me a guaranteed profit (at a nice rate of return) with an opportunity to make an even greater profit if the market settles down somewhere around 120 at expiration. The free fly (one where I buy the wings for exactly 5.7) would only give me a free oportunity to make a profit. I really wanted that guaranteed profit so I did not complete the fly.

Being able to get into a free butterfly that isn't that far out of the money in return for taking on an hours worth of directional risk seems like quite a gift from the market. (Although I don't have enough experience with this type of trade to really know how often this happens.) I hate to pass up good fortune. I fear that I was greedy. Holding a naked short overnight is a order of magnitude more risky than holding one for an hour. I could have mitigated the risk, and still heald out the oportunity to make a nice profit. The 123 call has a small delta and won't go down a whole lot as the market goes down. Most of the price reduction that will allow me to get into the fly for a credit if the market goes down will be in the 117 call as it is deeply in the money and has a high delta. It would have made sense to at least buy the 123 call and mitigate some of my upside risk. In hindsight, I regret not doing this.

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