If Only I Had Been Smart Enough …..

Another Hero at Hero’s Square, Budapest

In my recent Rutherford Review Post I spent a little time describing some of the features of Fibonacci Technical Analysis. I mentioned that I don’t usually use this analysis for Investment purposes (other than, maybe, to help me set stop loss orders) but that I sometimes use it for other “trades”. For fun, since I have not posted anything on Options for a while, and as an example of how I might have used the information available to me on 14 October (but didn’t, hence the “If Only I had Been Smart Enough …” title of this post), when I accepted that we had moved out of the down channel:

I drew the Fibonacci retracement levels from the 1 September high to the 4 October low that established the projected 161.8% retracement high (at an undefined time in the future) of ~4720. If I felt that this price was likely to be reached, and within about a month (the time spent in the downtrend), then I could have placed one of my favorite Option trades – an unbalanced Butterfly spread centered at 4720. Since we cannot trade the SPX I would have done this in SPY Options (one-tenth the size of SPX) and it might have looked like this:

the important point here is that I have used the Fibonacci analysis to identify the center point of the Butterfly spread. This trade has a maximum risk of $312 if SPY does not move above 450 at expiration (4 Oct price = 442.5 – therefore ~1.7% move) – although I would not hold this to expiration so the potential loss is less than this and probably better than break-even with SPY at 450 – 12 days before expiration (~7 Nov, 3 weeks from when the trade would have been placed).

If we run this trade through to today we get the following picture:

where we see a $989 profit – and I would be out of this trade with a 300% Return on Investment. I don’t think the probability of SPY closing at this level (~470) in 2 weeks time is worth the risk of holding the position in the hope of wringing the extra $800 theoretical maximum profit out of the trade. It would be too nerve wracking with significant risk of losing at least a portion of the $900 currently available.

Now, the above trade suggests that I was reasonably bullish on 14 October and thought that price might go through the 470 target price – so the position has no risk to the upside. If SPY continues higher, above 470, I am guaranteed at least $188 profit even if I do nothing.

However, I might not have been that bullish (and I’m not), so I might have been more worried about my losses to the downside. This being the case I could move my risk to the upside by “unbalancing” my Butterfly spread in the opposite direction:

in this case I only have $48 at risk if SPY does little or nothing. SPY would have to close above ~480 at expiration before I would lose money – even if I did nothing – but I have to go through my maximum profit price of 470 before getting there – so I’m likely to exit before I get there. Maximum loss – if I fell asleep and did nothing – would be $1048 with price above 490 at expiration.

Fast forward this position to today:

and we see that we have $350 profit – seven times (700%) the $48 most probable risk – but $550 less than the first trade above (where we had $312 risk rather than $48)..

We balance risk/reward and make our choice as to which (or other, similar, trade) might be more attractive to us – but, the main point here is that I would still be using the 470 price as the center price target for maximum profits for my butterfly trade.

David