A Bearish Butterfly Play

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It is easy to get into a lull with the market. The memories of 2008 and 2009 have seemed very distant, even forgotten. The short, small correction in November also seemed like just a passing moment of time, something between surreal and imagined. In only two days and a few hours of trading though, all those memories come rushing back to traders. Calls for a crash, a correction, a retreat all come flooding into the market place. Equities have been overheated and due for a pullback, but is this a buying opportunity or the siren's call of a bear in waiting?

This pullback may be the start of a new consolidation trend with more sideways action and volatility than we've seen over the past six months rather than the end to equities as we know them. Of course, the start of any trend means an end to the previous trend, which was straight up since September. We did see one pullback very similar to this current pullback, and that occurred in November 2010. The SPDR S&P 500 ( SPY)retraced about 4% of its bullish move. Currently, the market has dropped nearly the same amount over the past three days. Given the heightened political climate, it is very easy for the market to move past that level on this downward trajectory; however, I don't think the current move down will go significantly beyond support.

If the SPY were to mimic the November move, then shares could trade to around $128.64, which is right near current support of $128.79 in the form of the 50-day simple moving average (SMA). There is some support around $130.34 being tested today, but I would rather concentrate on the 50-day SMA. The move in November took the SPY to the $118 level, which is not an area I believe we'll see before March options expiration, so I want to use this level for the basis of a bullish InterETF spread. The spread will create a net credit I am then going to use to buy a bearish play much closer to the current price on the SPY.

For the net credit, I am buying ProShares Ultra S&P 500 Fund ( SSO) March 42 puts while shorting ProShares Ultra Short S&P 500 ( SDS) March 26 calls. I will be going long five of the SSO contracts for each 12 contracts I short on the SDS. I will then use the proceeds of the 5x12 ratio to buy two of the following skip-strike butterflies: long 1x SPY March 127 put, short 2x SPY March 125 puts, long 1x SPY March 124 put. The net cost of this trade should be zero, basically only the use of margin. The SPY would have to fall around 9% for the SDS short calls to move into the money, yet it only has to fall 3% for the put butterfly to move into the money.

The move to get the SDS short calls into the money would have to take the SPY down to around $118 per share or around the November lows. I just don't see that happening by March expiration. However, I could see the SPY overshooting the downside support in the $128.75 area and carrying as low as $125 with $122 being a worst case scenario. Even if the SPY overshoots the lowest leg of the butterfly, the put butterfly would still hold a value of $1.00.

This is a bearish play. To be bullish would mean buying fewer put butterflies or skipping them altogether. This move is to play a measured move lower. The time frame is really too short to benefit from any volatility decay possible with the leveraged ETFs; however, it is possible to close this trade early if the market stays in the current range or drifts lower because time decay will start to eat away at the premiums on the SSO and SDS over the next few weeks. This trade isn't for the faint of heart, but it certainly offers a solid risk-reward scenario for sheepish bulls and bears alike.

At the time of publication, Collins was long SSO puts and SPY put butterflies and short SDS calls.

Timothy Collins has worked as a financial adviser since 1999, focusing on portfolio customization, with a concentration on correlation arbitrage and risk-managed growth. He started Collins Capital Advisors in 2007, which has evolved into TangleTrade Management, LLC. TangleTrade is an RIA firm dedicated to formulating customized risk-managed investment strategies for individuals and small businesses. TangleTrade Management now manages the TangleTrade Fund, a correlation arbitrage hedge fund utilizing the trademarked InterETF strategy.

Prior to joining his first firm, American Express Financial Advisors, in 1999, Collins worked as a staff accountant for United Information Systems in Bethesda, Md. He has also worked as a financial analyst for Securities Pricing and Research in Annapolis, Md. Collins is a graduate of McDaniel College (formerly Western Maryland College), with degrees in business administration, economics and sociology and is a winner of the Bates Prize.

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