The Ideal Trade For This Nervous Pre-Election Market

We are sitting in chart environments where spikes into higher prices are getting sold off into the election cycle. Chip giant Taiwan Semiconductor (TSM) also sells off its spikes before running higher. This makes for an ideal candidate for the trade environment ahead.

Here's the TSM trade I'm thinking of.

Given this environment, a long put butterfly is the best trade. Here's what you need to understand about the long put butterfly:

A long put butterfly is positioned so the "long" wing of the trade gives us a likelihood of returns, while using the "short" wing to finance part of the trade.

Today, we will use a put butterfly, with a twist. Instead of the standard 1x2x1 structure, we will use the 1x3x2.

This long put butterfly holds 1 long put spread (a bearish position) and 2 short put spreads (a bullish position) that share the middle strike. Please notice the side that holds the short put spread is tighter so that the risk is bounded and there is no need for additional margin.

• Buy to open 1 TSM 20 Dec 190 puts
• Sell to open 3 TSM 20 Dec 180 puts
• Buy to open 2 TSM 20 Dec 175 puts

_{Chart courtesy of Benzinga Pro}

The put butterfly above will cost $1.18 at this writing and it also represents the max loss for this position. This makes the max profit $190 – $180 – $1.18 = $8.82 (outside of commissions). Total profits will begin to erode if the price of $TSM stays below $180.

Our maximum exposure is the cost of the butterfly, and it is also the max risk of the position.

The goal of taking long butterflies like the one above is to take advantage of higher implied volatility as the undercurrent of markets shift to participate in an outsized move in either direction.

That's perfect given TSM's key levels. After breaking to new highs, TSM is statistically likely to fill its gap. This baseline support is near $190 with much of the volume crowding around $180 – which is why I chose the middle strike as the ‘sweet spot' for potential maximum returns.

The strategy result provides three choices to exit the trade:

1. To sell the butterfly once it gets to an acceptable profit margin for you. I customarily look for 100% to 300% profit for these kinds of trades.
2. To sell the spreads once it hits your loss threshold as determined by personal risk, which will happen with extreme movement. I customarily look at about 65% though depending on my size, I will choose 50%.
3. To sell the butterfly spreads into the week before expiration, if all is going well and you have decided to hold the trade into closer to the end of expiration (I have had many a trade go sideways taking it down to the wire and not capturing gains, so I do not advise this).

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Image via Wikimedia Commons