Can You Catch the Google Butterfly?

by John Kmiecik | September 20, 2012 8:52 am

Can You Catch the Google Butterfly?

Even though Apple (NASDAQ:AAPL[1]) has garnered most of the attention lately[2], let’s not forget that it was Google (NASDAQ:GOOG[3]) that made it to $700 first.

Just like two thoroughbreds racing neck and neck, it looked like Apple would when the race back in late August until Google pulled it out in the end. Just this week, though, AAPL finally crossed the $700 line … way behind the mighty GOOG. The key difference is that Google has been there before, whereas Apple is trading at all-time highs. GOOG hit an all-time high back in November 2007, trading at just above $747.

Both companies are on the cutting edge of technology, and it probably can be debated which one has the lead in that department — even though the Apple diehards out there will say AAPL has no peers. But here’s what looks good about GOOG from a technical aspect: The stock still has some room to move higher and has a resistance area right around $747 that it eventually should be able to get past.

The wild card in this equation is earnings. Google is expected to announce earnings on Oct. 10. What if a trader has a bullish bias after the announcement?

A credit spread might make sense to take advantage of elevated levels of implied volatility, but depending on how it’s implemented, a trader usually will risk more than he or she stands to profit. Is there a safer way to sell volatility and create a relatively low-cost trade with a fairly large range and a chance to earn substantial profits?

The answer is a resounding yes — and it’s called a directional butterfly spread.

The long butterfly spread involves selling two options at one strike and the purchasing options above and below equidistant from the sold strikes. Butterfly spreads generally are thought of as being a neutral strategy. What some traders don’t realize is that butterfly spreads can be used directionally by moving the “body” of the butterfly out-of-the-money and using wide strike prices for the wings.

The logic behind the trade is that the trader has a specific target and time frame for the stock with a decent range to profit. The goal of the trade is to benefit from time decay as the stock moves closer to the short options strike price at expiration. The short options expire worthless or have lost significant value, and the lower strike call on a long call butterfly or higher strike put for a long put butterfly have intrinsic value.

Here is a trade idea on GOOG that counts on the stock to be trading above $750 (but not above $800) by October expiration:

GOOG — $727.50

Creating a long butterfly spread on GOOG entails:

The total cost of the spread will be $3.40, which is the most that can be lost. The maximum profit will be $21.60 ($25 strike difference – $3.40 debit).

Since the butterfly has two wings, there are two breakeven points. Add the net debit to the lowest strike and subtract the net debit from the highest strike. For this trade, it’s $753.40 ($750 + $3.40) and $796.60 ($800 – $3.40). If GOOG is trading between $753.40 and $796.60 at October expiration, the trade will be profitable. Anywhere outside of that area and the trade will not be profitable. If GOOG finishes at $775 (body of the butterfly) on October expiration, the maximum profit is achieved ($21.60).

One of the biggest disadvantages of a directional butterfly spread is that its maximum profit potential is reached close to expiration because time decay has eroded away. That means a trader will have to be patient, which usually is a good quality for a trader to have — but not necessarily a common one.

As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities.

Endnotes:
  1. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  2. has garnered most of the attention lately: http://investorplace.com/2012/09/apple-clears-700-tuesdays-ip-market-recap-aapl-fdx-enr-anr/
  3. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG

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