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.
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.
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).