With SPY implied volatility spiking to its highest level in six weeks, we’re entering a (short-vega) butterfly to hedge our delta bias, as follows:
Day limit order
Buy to open 2 SPY Aug 135 puts
Sell to open 4 SPY Aug 129 puts
Buy to open 2 SPY Aug 123 puts
for a net debit of $1.73 or better.
We’re allocating a dollar amount to this trade equal to the allotment for each regular calendar-spread position. For autotrading purposes, the 2/4/2 contracts specified above represent one base-position unit.
Analysis: After a drop of more than $2.50 in the SPY share price, we have a lot of delta to hedge, and our strategy is to sell implied volatility, by opening a butterfly (rather than buy vol as we do when buying a calendar spread), whenever IV is in the upper half of its 3- to 6-month range. This trade reduces portfolio delta from more than 6% of capital at risk to about 1.5%, while reducing vega from 7% to about 3.4%.
I’ll have more about the implications of this after a look at our new portfolio risk profile:
The take-away from the above graph is that we’ve moved our downside breakeven more than three points lower, while keeping our upside breakeven at the very forgiving one-standard-deviation mark. If implied volatility at expiration is about where it is now, the model gives us a 51% probability of ending the cycle in the black.
So if the market continues to decline, with implied volatility rising (presumably), wouldn’t more vega be better? The simple answer is “Yes,” but options are never simple. Considering the current perception that the greatest risks—a U.S. default and/or downgrade of the nation’s credit rating—are near-term, if fear increases we’re likely to see front-month (August) IV rise faster than back-month (September), temporarily offsetting any paper gain from the latter. That makes an at- or near-the-money calendar no more attractive than a butterfly.
The beauty of the butterfly (if you’ll pardon the poeticism) is that we can adjust it to our advantage in either direction. In a market sell-off we can roll the short side down with another short-vega trade, which would benefit from an increase in IV. If Washington resolves the debt-limit impasse tomorrow, the drop in implied volatility would cushion the loss on today’s trade, and we can roll the long side of the butterfly up, both spreading out risk and selling more volatility in what likely would be a new downtrend in IV.
I realize this is pretty advanced, esoteric options geekery, and less experienced members might find it confusing. However, unlike most other options-education newsletters, we don’t try to make options trading seem simpler than it is—I’ll say it again, “Outperforming the market is never easy.” Advanced members already know this, and the sooner newer traders learn it, the better for their bottom line. One thing all members can count on, though, is that we’re happy to answer any questions from members, advanced or basic—just drop me an e-mail at email@example.com.
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