To keep up with the relentless selling, we’re rolling the DC #2 portion of our position at 122 down to 116, as follows:
Day limit order
Buy to close 4 SPY Aug 122 calls
Sell to close 4 SPY Sep 122 calls
Buy to open 4 SPY Sep 116 calls
Sell to open 4 SPY Aug 116 calls
for a net debit of $0.12 or better.
Note that the 4 contracts specified above represent the number of contracts in the Aug/Sep 122 call calendar that came from Double-Calendar #2.
Analysis: Under normal circumstances, our strategy calls for opening yet another butterfly hedge into today’s spike in implied volatility, but we recognize that traders don’t have unlimited capital to fight an outlier event like we’ve seen this week. So we’ve chosen to free up some margin by closing the position working most against us at this point, and to roll some of our calendar position from the center of the portfolio risk curve (where gamma is becoming dangerously high, at least for the current market environment) down to a lower strike, for a small additional debit.
Today’s two trades are keeping us in the game, moving our expiration breakevens down to SPY $114.94/$126.78 and keeping our projected probability of profit over 40%. We’ve cut portfolio delta, in proportion to total capital at risk, from nearly 5.8% to about 1.8%. Considering how low our portfolio vega remains, this is another conservative delta adjustment, as we continue to watch our risk in case of an explosive reversal to the upside.
So why are we hedging with a calendar spread below the market when implied volatility is so high? The answer is volatility skew, specifically the high ratio of front-month to back-month implied volatility. At the 116 strike, the implied-volatility ratio in the calls is in the vicinity of 113%—compared to a typical figure of 95% to 98% in most of our trading cycles. That, in large part, is why we can make this rolling trade without increasing volatility risk, as would ordinarily be the case. We’re paying for a lot of premium to buy the September 116 calls, but compared to a “normal” month, the amount of August premium we’re selling is even higher.
Our next adjustment to the down side would, ideally, continue to spread out delta/gamma risk while keeping vega fairly neutral. Unfortunately, the best way to accomplish this—rolling down the long side of BF#3 by selling an iron condor—might require excessive margin. What we may have to do instead is roll more of our contracts from the 122 calendar position and/or close BF#3 and use the credit to buy a fourth butterfly hedge centered at a lower strike.
I’m well aware of the commissions we’re racking up with all these hedges and adjustment trades. This is an extremely unusual month, but it reinforces the importance of negotiating the lowest possible commission rate. Of course there are limits to how far even the best discount options brokers will go to keep customers happy. So far, though, the trades and adjustments we’ve made have kept our potential profit at expiration high enough to cover commissions (assuming a reasonably good rate of $0.90 to $1.00 per contract) and more. Enough said for now—the last thing a trader wants to do is count on profits before they’re realized.