Supplemental Trade Alert: Open JNJ December Butterfly Hedge
Mon, Nov 29, 2010 | Frank
With implied volatility for out-of-the-money JNJ January puts near 17%, instead of adjusting a calendar position down to a lower strike we’re going to use our Supplemental Trades portfolio to demonstrate the butterfly hedging strategy currently under development. Note that the order below presumes participation in all of our currently open ST positions, and we’re determining position size by the number of contracts needed to offset about half of our current portfolio delta. The delta of the butterfly is about –29 per 1-lot, so to hedge a portfolio allocation with a current delta of 400, for example, we’d be looking to buy a 7-lot (14 contracts at the short strike).
Here’s the base-position (1-lot) order for this morning’s hedge trade:
Day limit order
Buy to close 1 JNJ Dec 62.5 put
Sell to open 2 JNJ Dec 60 puts
Buy to open 1 JNJ Dec 57.5 put
for a net debit of $0.74 or better.
Note, again, that we want to size this hedge position to offset about half of our current portfolio delta.
Analysis: In this Supplemental Trade, we’re applying the two key changes that we’re considering as measures to make the Calendar Options strategy more robust. One is the intraday adjustment trigger: We’re tightening our portfolio-level stop-loss, to about 15% of total capital at risk or about 12% of total capital allocated to the portfolio, whichever is smaller.
This means our whipsaw filter won’t be as effective, but the other change—establishing a butterfly position to hedge our portfolio when an adjustment trigger coincides with a spike in implied volatility—should lessen the risk in case we do get whipsawed by a short-term sell-off. By selling volatility when it’s relatively high, we can expect to take a smaller loss on the hedge if the stock bounces back and, theoretically, IV comes back down, than we would with a calendar hedge at the same strike.
This trade—when sized as specified in the alert—by definition cuts the delta of our Supplemental Trades portfolio by about half. Delta per dollar at risk drops from about 15% to about 5.8%. That 60% reduction is just fine, though, considering the fact that we’re also offsetting vega, as a percentage of capital at risk, by more than 20%.
Our new Supplemental Trades portfolio risk profile is shown below:
To determine our new downside price-level risk-management threshold, we’re averaging the adjustment points for the currently open positions with the lowest short strike after this trade (which is what we typically use for a triple-calendar). However, if JNJ doesn’t stay above about $61.50 for the next few days, we’ll be hitting our stop-loss trigger again before the price-level adjustment point…in that case, we’ll add to the butterfly hedge position.
The new upper adjustment point, as noted in last month’s butterfly Bonus Trades (1, 2), is where the butterfly begins to lose value over time. That’s currently at about JNJ $62.25, but it will slide down as we get closer to expiration. We have two options for unwinding this hedge: We could simply sell the butterfly, or we could roll it into a more delta-neutral iron condor. The latter would require additional margin, so it would be a good idea for members who are following this month’s Supplemental Trades to make sure they have plenty of margin available (approximately 125% of initial portfolio allocation). If that’s not possible, just closing the butterfly is a perfectly valid alternative.
*NOTE: As a Supplemental Trade, this trade is optional and is primarily intended for more experienced/risk-tolerant subscribers. It will *not be autotraded*, and it has no bearing on our core newsletter portfolio; however, we will follow up by posting any additional entry or adjustment trades that the Calendar Options risk-management approach may call for. Also note that it’s important for anyone who chooses to participate in Supplemental Trades for a given cycle to follow *all* Supplemental Trades in that cycle if they wish to match our risk-management profile.Tags: butterfly, delta, entry, hedge, JNJ, risk management, Strategy, vega
December 2nd, 2010 at 12:34 pm
While I agree that modifying the BF into an IC is a valid adjustment stategy, it seems that approach doesn’t make much sense here given the low option prices.
December 2nd, 2010 at 1:02 pm
An astute observation, Hans–but hedging is a matter of context.
We’re already sitting on a pile of positive vega, so if options prices are so low that they’re likely to go up, we’re covered by our core calendar trades. On the other hand, we’re adjusting the hedge butterfly to protect ourselves from continued bullishness, which we can expect to drive IV lower and thus benefit the new condor position.
Lastly, the expectation for a hedge trade is that it will lose money if the market reverts to the mean (which generally is what we want to happen). The proposed hedge-adjustment strategy simply minimizes the loss so that the hedge doesn’t hurt our net P/L as much.
You are quite right, though–we generally want to buy volatility when it’s low and sell it when it’s high. However, when the primary goal is to manage risk, we sometimes do the opposite, to guard against a continuation of the trend in IV.
Thanks for the insightful comment. Member comments, questions and suggestions help us make our strategies and services better and better.