Nvidia (NVDA) has been a hot stock lately, rallying from 550 to 775 in a short space of time.
Perhaps now the stock needs to go through some sideways consolidation before it can start the next leg of the rally.
If that occurs, traders might like to look at butterfly spreads on Nvidia stock.
Butterfly spreads profit when the stock stays within a defined range, ideally with an associated drop in implied volatility.
Setting Up The Butterfly Spread In Nvidia Stock
A typical butterfly would be constructed as follows:
- Buy 1 in-the-money call
- Sell 2 at-the-money calls
- Buy 1 out-of-the-money call
Here is how that might look on NVDA stock.
- Buy 1 July 16, 715 call @ 56.95
- Sell 2 July 16, 765 calls @ 25.50
- Buy 1 July 16, 815 call @ 9.35
The total cost of the trade is $1,530 and that is the maximum loss potential.
The maximum gain is $3,470. We calculate it by taking the difference in strike prices less the premium paid ($5,000 less $1,530). The break-even prices are 730.30 and 799.70 (765 plus and minus 34.70).
A butterfly trade has a tent-like shape with the potential for large profits around the short strike. It is important to keep in mind that achieving the maximum profit is a rare occurrence. So, a good aim for a butterfly trade is to make a 20% return on capital at risk. In this case that would be around $306.
When To Adjust Or Close The Trade
In terms of risk management, I would adjust or close if either of the break-even prices were touched.
Butterfly spreads can be a bit confusing for beginners, so it is best to paper trade this and see how it performs.
Earnings are set for mid- to late August, so this trade should have no earnings risk.
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This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions. Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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