Bonus Trade: SPY November Butterfly

This Bonus Trade was published on our Calendar Options members-only blog on Friday.

Our paid newsletter strategies are predicated on the expectation of mean-reversion (with risk-management rules for containing losses in trending markets)—in implied volatility as well as in price of the underlying. But when we find ourselves in a strong bullish trend, it’s often desirable to both increase delta and decrease vega. One great way to do this is with butterflies. Traders who want to take a directional bias may find butterflies especially useful in a bullish environment; however, in the context of our market-neutral strategies, we’re more interested in using butterflies as hedge positions.

The Thesis

For example, the SPY November 121/125/129 call butterfly carries about 24 delta per 1-lot position. Its negative vega (about –2.2/lot) promises additional gains as IV drops, and its marginally positive theta with SPY near the breakeven point grows into a significant part of the potential profit if the market continues to climb. In addition, it’s a defined-risk position, with a maximum loss equal to the cost of the trade (less than $1.45/share). These three characteristics give a directional butterfly an advantage over vega- and theta-neutral hedges such as stock, a synthetic/combo options trade, or futures.

Of course, some disadvantages come along with the benefits. A butterfly’s upside potential is limited, a significant increase in implied volatility can push down the net value, and theta turns negative if the underlying price moves too far beyond the expiration breakevens. Consequently, risk-management techniques are just as important when trading butterflies as for any other strategy. Because this is a true bonus trade, though (which means we’re not planning any follow-up), I won’t get into the more complicated aspects of our butterfly risk-management strategy and instead merely give target exit points.

The Trade

Buy 1 SPY Nov 121 call
Sell 2 SPY Nov 125 calls
Buy 1 SPY Nov 129 call

This trade is currently mid-priced at $1.43/share. To use it as an upside hedge for our current calendar-spread portfolio, one would calculate how much delta offset is desirable (typically between 60% and 100% of the current portfolio delta) and trade as many lots as are needed to purchase that total delta. For example, at an initial allocation of $2000 per Calendar Options trade, total portfolio delta currently would be about –100. To offset 70% of that delta, one would need 100 × 0.7 ÷ 24 ? 3 contracts at the wing strikes and 3 × 2 = 6 contracts at the center strike.

A simple exit strategy is to close the position if either of two things happens:

  • SPY climbs past the center strike, turning the butterfly delta-negative, or
  • SPY falls enough to turn the butterfly theta-negative (currently at approximately $121.75).

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2 Comments For This Post

  1. Sid Says:

    total portfolio delta currently would be about –100. To offset 70% of that delta, one would need 100 × 0.7 ÷ 24 ? 3 contracts at the wing strikes and 3 × 2 = 6 contracts at the center strike.

    Hi Jared, could you please explain the 24 ? 3 contracts at the wings and the center strikes . can you explain the mechanics of calculation . thanks

  2. Frank C. Says:

    Sorry about that, folks–apparently the HTML code I used for the “approximately equal to” (wavy equal sign) isn’t rendered properly in all browsers. The calculation, annotated version, would be (100 current delta) X (70% desired offset) / (24 delta per 1-lot) is approximately equal to 3 lots in the butterfly.

    A typical, balanced butterfly has twice the number of contracts short at the center strike as it has long at each outer strike. That makes the short position covered in both directions. So a 3-lot would be +3 121 calls, -6 125 calls, +3 129 calls.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More


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