Investing with No Downside Risk: A Strategy Breakdown
This article explores a trading strategy that aims to eliminate downside risk while generating potential returns. It involves buying 100 shares of a stock combined with a married put and a call ratio spread. Let's break down how to set it up, manage it, and track it.
The Strategy: A Combination of Four Trades
The core idea is to implement a specific options strategy alongside a stock purchase, designed to be perpetually rolled over in an account. This involves four trades:
- Buying 100 shares of a stock.
- Purchasing a married put option.
- Implementing a call ratio spread.
Setting Up the Trade: A Visa Example
Let's illustrate this with Visa (V). The first step involves analyzing the stock's valuation. Investing.com's fair value indicator suggests if the stock is over or undervalued. The strategy focuses on setting up a call butterfly near the at-the-money price.
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Determining the Butterfly Center: Instead of centering exactly at the money (e.g., 345), if the stock is slightly overvalued, you can shift the center of the butterfly slightly lower (e.g., 340).
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Building the Butterfly: A 15-wide call butterfly can be created by buying a lower strike call, selling two calls at the center strike, and buying a higher strike call. For example, buy the 325 call, sell two of the 340 calls, and buy the 355 call.
Initial Risk and Reward
Initially, this setup costs a debit to open. The potential loss is limited to the amount paid to enter the trade, while the potential profit is significantly higher. For instance, a $200 investment could potentially yield a $763 profit if the stock price pins at the center of the butterfly at expiration. However, the probability of this exact scenario is often low, since it requires a very precise pin.
Converting to a Zero-Risk Trade
The key to eliminating downside risk lies in adjusting the initial butterfly setup.
- Changing the Lower Leg: Replace the lowest leg of the call butterfly (the long call) with a put option at the same strike price.
- Adding a Stock Leg: Buy 100 shares of the underlying stock. This can make the trade costly initially but provides the risk mitigation.
By owning the put option, even if the stock price drops to zero, the put protects your investment, effectively creating a lossless trade.
Analyzing Potential Returns
While downside risk is eliminated, the potential profit is capped. The minimum profit can be calculated based on the cost of entering the trade. For example, if the trade costs $32,900 and the minimum profit is $100, the return on capital is very small. However, you also collect dividends from owning the stock and have the potential to make more if the stock trades within the butterfly's profit zone.
Managing and Rolling the Trade
The strategy involves actively managing and rolling the options position to maximize returns. A rolling options record keeper is used to track the trade's performance and make adjustments.
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Tracking Performance: Monitor the stock price relative to the butterfly's profit zone.
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Rolling the Position: Close the existing options positions and open new ones with different expiration dates and strike prices, adjusting the butterfly's center as needed.
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Adjustments: This might involve selling existing options, buying new ones, and potentially receiving a net credit.
Example Roll: A Live Account Demonstration
To roll the position, the existing butterfly is closed out (selling the long put, buying back the short calls, and selling the long call). Then, a new butterfly is established with adjusted strike prices and expiration dates. The goal is to collect a credit during the roll, which further increases the potential minimum return on the trade. This process is demonstrated live with the trader adjusting the prices to get the best possible fill. Commissions are also recorded to accurately track the trade's overall performance.