It’s going on a year now since we introduced butterfly spreads into the Calendar Options strategy, giving us a way to hedge delta and volatility risk, and another adjustment strategy to add to our trading toolbox. A standard butterfly combines two vertical spreads, one credit and one debit, that share the same short strike—and expiration date. But there’s nothing in the options rule book that says we can’t buy one long leg at a later expiration (or both…but that would be a variety of double-diagonal), to create what’s known as a “calendar butterfly”.
Depending on the strikes and width of the time spread, several characteristics of the calendar butterfly can provide an advantage under certain circumstances. For one, you can get a lot more delta per dollar at risk, which makes it good for directional hedging. The longer-dated position also carries more vega, which makes the calendar ‘fly more volatility-neutral than a plain-vanilla butterfly. Buying farther out in time also reduces the rate of premium decay near the money, and it gives us another implied-volatility profile to work with.
Having another dimension to play with in the IV surface (implied volatility plotted across the range of strikes and expirations) is critical when the front-month volatility “smile” curve is steep and narrow. Today, for example (and not coincidentally), February call volatility (red line in figure below) is almost a point lower at the 136 strike than it is at 141, whereas IV for the March calls (yellow line) continues to decline through the 141 strike.
So if we wanted to hedge negative portfolio delta with a standard SPY Feb 131/136/141 butterfly, we’d have to buy the relatively expensive Feb 141 calls, and the net delta per dollar at risk would be about 7%. The risk profile for this trade is shown below:
Buying the 141 strike a month farther out, on the other hand, would give us a net delta per dollar at risk in the 9.7% range, without selling volatility at the low point of its range over the past 4½ years. As shown in the risk profile below, the SPY Feb131/136/Mar 141 calendar butterfly is virtually vega-neutral.
We’ll see how this strategy (though not necessarily at the same strikes) affects our current portfolio risk profile when I post the analysis for this afternoon’s upcoming trade.