Butterfly on Shopify

Recently the Royal Bank of Canada lost its title as our country’s most valuable company in terms of market capitalization. For two brief weeks, Shopify sat at the top of the heap.

Chart 1: Royal Bank vs. Shopify May 31, 2020

Source: Bloomberg

SHOP’s run has been a sight to behold.

Chart 2: Shopify (TSX:SHOP) May 31, 2020

Source: Bloomberg

During the darkest moments of the corona crisis, SHOP shares changed hands at $435. Now, not even three months later, they are ticking above $1,000. The rise has been nothing short of remarkable.

But will this trend continue, or is SHOP due for a big pullback?

It is often difficult to time the exact moment that a strong stock like SHOP will correct. However, with a move as powerful as what we have seen over the past few months, the chances of SHOP simply going quiet are low. The bull move will most likely either continue to accelerate, or there will be a sharp and swift price correction.

But how should this scenario be played?

One interesting option strategy in this environment is to sell a PUT BUTTERFLY spread. This might sound complicated, but it really isn’t.

First let’s tackle what a long position in a put butterfly spread looks like. It consists of the following:

Where X = the middle strike and a = the equal distance to the outer strikes

Click on the following link to consult the Long Put Butterfly Strategy Guide:

https://www.m-x.ca/f_publications_en/strategy_long_put_butterfly_en.pdf

For our SHOP example, we will use X = 1,050 and a = 100.

This means our long SHOP butterfly will consist of:

Long 1 SHOP 1,150 put
Short 2 SHOP 1,050 puts
Long 1 SHOP 950 put

A long butterfly position will profit if future volatility is higher than implied volatility. The purchaser of the butterfly wants the underlying to expire at the level where he/she is short on the 2 puts. That is the point of maximum profit. As the price moves away from the strike, the profit eventually turns into a loss (but the maximum loss is limited to the spread between the strikes).

However, we just discussed how SHOP is likely to either continue higher on its tear or correct sharply. Therefore, a long butterfly is exactly the wrong position to implement in this situation.

But this means that a short butterfly is the ideal candidate to express our view. To understand the short put butterfly, consult the following strategy guide: https://www.m-x.ca/f_publications_en/strategy_short_put_butterfly_en.pdf

Here are the positions, using the mid-market prices as of May 29, 2020:

Table 1: Shopify Butterfly

Source: Bloomberg

And this is what our P&L diagram looks like at various points before expiry, where the green line represents the potential P&L at expiration:

Chart 3: Shopify Payoff Profile Calculated as of a May 31, 2020 Start

Source: Bloomberg

As you can see, the maximum loss occurs if SHOP stays at the current price. This maximum loss is the spread between the wings ($100.00), or $10,000 for every 1/2/1 butterfly combination, less the $2,738.00 credit received. This maximum loss would be $7,262.00.

However, SHOP moving above $1,150 or below $950 will result in our maximum gain, which is the total credit received of $2,738.00. Our breakeven ends up being anything below $977.38 or above $1,122.62.

Given the way SHOP is moving these days, this eventuality seems probable. But if you don’t agree, then the long butterfly position provides an easy way to take the other view.

The good thing about both long and short butterfly positions is that your risk is capped. You can construct specific payoff profiles depending on your view of where the underlying will be at expiration, while knowing your maximum gain and loss in advance.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.