This column was originally published on RealMoney on Oct. 12 at 2:15 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.
describing how to use butterfly spreads to establish a limited-risk bearish position in
seems to have goaded those who believe shares will head higher when the company reports "blow-out" numbers next Thursday, Oct. 19, to ask how a similar bullish strategy could be constructed.
So let's assume you think shares of Google will rise back to $460, which is basically the area where it left a downside gap after hitting an all-time high of $475 a share last January and might prove to be both a point of attraction and a resistance level. To set up that as the level at which the maximum profit is achieved, use $460 as the middle or body of the butterfly. Here is how it would be constructed at current prices with shares of Google trading around $425.
Buy 1 October $440 call at $7 per contract = ($7 debit)
Sell 3 October $460 call at $2.50 per contract = $7.50 credit
Buy 2 October $470 call at $1.40 per contract = ($2.80 debit)
The net debit is .... ($2.30)
As a covered position in which there is an equal number of contracts bought as sold, the risk is limited to initial cost, in this case that is just $230 for a 1x3x2 contract position -- a 10x30x20 contract position would cost $2,300 -- and would be incurred if shares of Google are below $440 or above $470 on the expiration day, Oct. 20. The maximum profit in this example is $1,770 -- the width between strikes of the long call minus the net debit (460-440-2.30=17.70) -- and would be realized if shares of Google land exactly at $460 on expiration. That's a 1:8 risk/reward ratio for only a one-week holding period.
Typically, to attain such attractive odds, a butterfly spread, whose maximum profit can only be realized at expiration, would need to be established several weeks prior to the expiration.
The reason the setup is available now and will be for the next few days, as it has been through the past three Google earnings reports, is that with the release date coming just one day prior to expiration, the near-term options hold onto all of their time premium. This translates into an extremely high implied volatility reading, which in turn keeps the value of out-of-the-money spreads relatively flat, making it easy to put on low-cost butterfly spreads.
Once the earnings are announced, most of the time premium will come out and the spreads will trade close to intrinsic value. That means even if you don't have to wait for exactly $460 at the close. If shares of Google are trading at $450 on Friday morning you will be able to sell out and close the position for around $9, which equates to around a $6.70 or nearly 300% gain for the one-week holding period.
This strikes me better (pun intended) than chasing some huge outsized move through the outright purchase of some out-of-the-money calls, let's say the November $450s for $12, which will require an 8% move just to reach the $462 break-even point, and of course will have to overcome the decline in IV that is sure to occur following the earnings report.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;
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