Fly high with a gold butterfly trade

Published: Sept 28, 2012 7:00 a.m. ET




Just when the euro monkey is off the market’s back, a riot here or a riot there gets the indexes rolling again.

We had the VIX up to a two-week high of 17.08 Wednesday on the thought that Spain cannot work themselves out or a crisis. I guess that is new news. The ECB said they would be there and so far that has not changed but riots get folks nervous. What also has not changed is that the big central banks are printing and printing is good for commodities. That brings me to one of my favorite plays for stocks with big numbers. Take a look at a butterfly in the SPDR Gold Trust exchange-traded fund GLD, -0.20%

Before looking at the trade construction, what is a butterfly? The trade is buy one contract, sell two contracts and buy another contract in three different strikes in the same month with the distance between the outer strikes ("wings") and the inner strike exactly the same. A six-point butterfly for GLD would be the 171/177/183 strikes.

The first thing to understand is how to build a butterfly. I like the fundamentals of the GLD for a butterfly but I look at different fundamentals. First off, the underlying security has to be a relatively slow mover. Gold had moved a couple of weeks ago but the 30-day realized volatility is around 12% now. That is pretty sleepy for the GLD and is more a symptom of the trajectory investors see in gold. They like it but are not buying it up as fast as they were. The next piece for a successful butterfly is relatively high implied volatility. November Implied Volatility in the GLD is trading near 16% so there is a nice premium to the underlying movement.

Next, look at the price and direction of the target underlying for the position. GLD is a $171.14 number as of this writing. Since I am looking in the up direction for GLD I will place the trade with bottom leg just at the money. Creating a butterfly with $1 between the strikes is a waste of money. It is better to set up a "fly" with a healthy distance between the strikes that is better suited to the range of activity for the target security. A 10% ($17) move in the GLD would be big at this point. A reasonable strike differential would be around $5-$7 between the strikes. This way GLD can move up and into the range where the trade will become profitable. A $1 distance between the strikes in a butterfly for the GLD would be like splitting an apple with an arrow at 100 yards (and you are not Robin Hood).

Finally think of the time for the trade to happen. For GLD I am going to give it until November and would hold the trade right through the election. Any turmoil is good for gold and I want to catch that. The target is around $177 for the GLD with the position generating a small amount of positive decay per day (about .50 on a 1/2/1 fly). The position pays the trader to hold it and should pay the trader well by mid-October.

Buy the GLD 171/177/183 Butterfly for a $1.06 debit with GLD trading $171.20 or higher.

Quote References

  • GLD
    -0.22 -0.20%

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