Using Butterfly Spreads In Inflation-Fueled Market

Simpler Trading Team

Simpler Trading Team

Is inflation truly receding to the point the Federal Reserve (Fed) will back off its hawkish attack to curb higher costs?

One economist doesn’t think so, and is warning stock market participants to check their enthusiasm because inflation may come back stronger.

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Inflation problem remains complex, ‘sticky’

Fed Chairman Jerome Powell this week stated that the “disinflationary process” has begun but will take a long time.

Fed actions last week raised the federal funds rate by 25 basis points and a string of “Fed speak” public events followed, and neither promoted confidence among stock market participants. The .25% increase was the eighth increase since March of last year. This boosted the federal funds rate within the target range of 4.5%-4.75% and the Fed goal is to get core inflation down to 2%.

Despite all central bank efforts core inflation hasn’t budged much, and that is a problem, according to a top economist.

Mohamed A. El-Erian, President of Queens’ College, Cambridge University and an advisor to Allianz and Gramercy, believes there is more complexity to upcoming inflation than what many investors realize.

He has publicly stated that there is a 75 percent chance that inflation will remain elevated or rebound to 40-year highs from last year.

“This would force the Fed to choose between crushing the economy to get inflation down to its 2% target, adjusting the target rate to make it more consistent with changing supply conditions, or waiting to see whether the U.S. can live with stable 3-4% inflation,” El-Erian stated in an op-ed for Project Syndicate earlier this week.

El-Erian sees the inflation issue as “sticky” where the Fed must keep up its tactics while waiting to see if inflation will come down. This could lead to inflation getting stuck at 3-4% over the second half of the year, he stated.

Overall inflation has fallen from its 9.1% peak last June to about 6%, but questions remain if Fed actions will pull inflation back down below 3-4%.

Using butterfly spreads for trading against inflation

This complex inflation equation ahead is encouraging traders to focus on more complex trading setups.

Traders are leveling up in this choppy, uncertain market with setups such as the butterfly spread.

The butterfly spread is a sophisticated and potentially profitable options strategy that can help maximize returns in a range-bound market. This setup is not for the faint of heart – properly executing a butterfly spread requires a high level of accuracy and a solid understanding of the underlying principles.

A butterfly spread involves simultaneous purchasing and selling options with three different strike prices. It is named after its butterfly-like shape on a profit and loss diagram. The butterfly is typically shaped like an upside-down “V” with the two outer strike prices making up the wings of the butterfly and the inside strike prices being the body – the most profitable part of the butterfly. 

Options trades using a butterfly spread are typically held until expiration and are used to profit from a specific price range or a neutral outlook on the underlying asset.

There are two main types of butterfly options: call butterfly and put butterfly. A call butterfly involves the purchase of two short calls sold at the same strike price, one long call purchased below the short strikes, and one long call purchased above the short strikes. A put butterfly has the same configuration, only using puts instead of calls. 

Butterfly options can be used to profit from a specific price range or to hedge against potential price movements in the underlying asset. They can also be used to generate income through the sale of the options. However, they also carry the risk of loss if the underlying asset price moves unexpectedly or if the options expire out of the money.

Understand important concepts for butterfly spreads

There are important concepts to understand before getting started with a butterfly spread. Here are terms to know: 

  • Underlying asset: The underlying asset is the financial instrument on which the options contracts are based. It is important for traders to choose an underlying asset that is highly liquid and has a sufficient level of volatility to generate profit potential.
  • Strike prices: The strike prices are the prices at which the options contracts can be exercised. In a butterfly spread, there are three strike prices: a low strike price, a middle strike price, and a high strike price. The strike prices determine the profit and loss potential of the position.
  • Expiration date: The expiration date is the date on which the options contracts expire. It is important for traders to select an expiration date that aligns with their investment horizon and the expected timeframe for the underlying asset’s price to reach the desired price range.
  • Net debit or credit: A butterfly spread can be created with a net debit (meaning the trader pays a net premium to enter the position) or a net credit (meaning the trader receives a net premium to enter the position). The net debit or credit will impact the trader’s potential profit or loss.
  • Profit potential: The profit potential of a butterfly spread is determined by the difference between the strike prices and the underlying asset’s price at expiration. The maximum profit potential occurs at the middle strike price and decreases on either side.
  • Risk profile: A butterfly spread has a limited risk profile, as the maximum loss is limited to the net debit or credit paid to enter the position. However, there is also the risk of significant losses if the market moves against the trader.
  • Market conditions: Butterfly spreads are best suited for range-bound markets, where the underlying asset’s price is expected to remain within a narrow range. It is important for traders to carefully analyze market conditions and choose an appropriate butterfly spread strategy.
  • Time decay: Time decay, also known as theta, is the rate at which the value of an option decreases as the expiration date approaches. In a butterfly spread, time decay can impact the profitability of the position, especially if the underlying asset’s price does not move as expected.
  • Adjustments: Butterfly spreads can be adjusted or exited if the market moves against the trader. It is important for traders to have a plan in place for how to manage their position if the market does not behave as expected.
  • Trading plan: A well-defined trading plan is essential for success with butterfly spreads or any other options strategy. It should include clear investment objectives, risk management parameters, and a plan for adjusting or exiting the position if necessary.

To follow how the team at Simpler Trading uses the butterfly spread in volatile markets, gain access today to our online community of traders.

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