The butterfly megathread

Discussion in 'Options' started by VixTraderdf, Oct 12, 2018.

  1. Hey guys, id like to get a discussion going here. TheBigShort did a great thread on calendars, and id like to have one on Butterflys. If any pros could give some input it would be much appreciated.

    @destriero got me thinking when he was posting in his sons journal about "flys into IV skew"
    I decided to do some research on that and found some things.

    How IV Skew affects Butterflys.

    "You're not going to find cheap wingspreads. Just saving you some time here. Butterflies are bimodal to most greeks but I don't want to go into the weeds. Spot at body strike if you're simply shorting vol, shotgun style; OTM if you want a pure play on gamma-modality and direction; ATM-ITM if you're after ddecay." @destriero

    "You think? I'd say that ATM/OTM fly (especially on the put side) is a pure skew play, just a slightly safer version of a 1x2. Eventually it does decay into an explicit delta position, but early on delta is pretty small and most of your daily pnl would be coming from vega and skew, right?

    PS. Sometimes when the skew is steep, you can find flys where you'd be long gamma and long theta... the "ultimate freebie" :D

    PPS. Think of it this way, a barrier put is a ultimate lopsided fly and it's mostly a skew and (less so) vega play" @sle

    "You can think of two separate types of flies. One case is where you are (synthetically or outright) trade OTM/2 x ATM/OTM, which is more or less just a bet on where the underlying will end up. You are a net seller of volatility and buyer of wings.

    Another case (which we are discussing) is when you trade ATM/2 x OTM/OTM, so the whole fly is actually sitting to one side. You are buying ATM volatility in this case and (mostly) selling the wings." @sle

    "From what I understand (and Atticus and others please correct me if I am wrong), the reason is due to index skew and sticky delta. Sticky delta is the phenomenon where the entire skew curve moves with the spot price, such that a strike with the same delta will have the same implied volatility.

    "An upside index butterfly will trade at a premium to the value under a flat volatility skew assumption, while a downside index fly will trade at a discount to it. All other things being equal, a flat skew curve is critical to the success of a fly. This essentially means that you are overpaying for an upside index fly, and underpaying for a downside index fly. E.g. if you purchase an upside SPX fly, and the spot price subsequently moves up to the body strike, then the body strike will have gained in implied volatility and hurt you. If you purchase a downside SPX fly, and the spot subsequently moves to the body strike, then the body strike will have lost implied volatility and will help you. The body strike really drives the fly value.

    If you buy an upside index calendar and the spot price subsequently moves to the strike, then the implied volatility of the spread will rise helping you. If you buy a downside index calendar and the spot price subsequently moves to the strike, then the implied volatility of the spread will fall hurting you.

    Since stocks obviously have a different skew curve than indexes, the opposite trading approach is generally the correct one for stocks.

    I credit Atticus for learning about this as he has spoken about this quite a bit in his journals and elsewhere on the site."

    "Choose a strike you think will be touched over the expected holding period. Buy a calendar at that strike if bearish. Buy a fly neutral to that strike if bullish." @atticus

    Some good words from the better traders ive seen here.
    So to get a dicussion going...

    1. How do you price butterfly spreads? TOS dosent allow you to adjust the vols for each strike, just as a total. What software do you guys use? Spreadsheets?

    2. What type of IV skew do you look for to open a butterfly spread? How does IV skew affect the butterfly?

    3. When is the best time to use a butterfly spread? How about an ATM fly, an OTM fly,
    a 1-3-2 & a 2-3-1?

    4. How about managing a fly when it has gained too much delta or -delta, dest mentions putting on offsetting flys. Do you ever delta hedge?

    Any other tips or things you would like to add to the discussion be my guest..If we could get some real life examples and see how things play out also that would be great too.
    Epicurus and billb2112 like this.
  2. destriero


    I'll reply later. I am atticus, obv.
  3. A thread about real trading might just convince me to start posting here again :)
    daniel5198 and billb2112 like this.
  4. Dolemite


    A thread digging in to the specifics of a butterfly would be fantastic. The vol smirk in SPX seems like it has changed structure in the past 12-24 months. Flys below the money take forever to make profits and when we move down and up the vol crush on the top strike really kills the trades. I am talking about a BWB with the shorts below the market. This was my bread and butter for years. I have been trading shorter term directional flys for the past few months instead.
    billb2112 likes this.
  5. destriero


    I can't talk much about structure right now, but I'll be glad to offer advice as the thread progresses.
  6. Ill try and help you get this thread going @VixTraderdf. Your questions are really going heavy into the skew/kurtosis and I think that is a bad place to start with butterflies. So lets take a look at it from a pure volatility stand point.

    Short gamma/vega + limited risk is very attractive to traders (gamma is usually very rich).

    You can trade butterflies in the implied space or take a view on implied/realized vol

    In Atticus journals, he traded butterflies in the implied space. Meaning he took a view on implied volatility and the terminal distribution of the underlying. So he did not delta hedge and not all his butterflies were ATM.
    But you can also trade a butterfly with an opinion on implied/realized vol -> Selling a straddle in which you delta hedge and buy the wings for protection.

    When it comes to 132 flys I will leave that for Des to comment on.

    For OTM flies it is a safer way of selling an I x J back spread. Play around with selling some back spreads in steep skew on your position builder, you will see how attractive the position looks except for the margin requirement and and max loss. So you buy an even further OTM leg to fix those problems.

    Hope that answers some questions :)
    billb2112 likes this.
  7. @TheBigShort

    Thank you for your input. If looking at FLYs in the implied space, do you have a method for determining that the edge is sufficient? Des has provided some guidance on this as a rule of thumb so I would like to thank him for previous feedback that was helpful.

    However, I am having trouble quantifying the real edge vs. what's just mediocre. So in certain situations a FLYs with 6/1 RR could be bad and in other situations, 3/1 might be great. I'm having trouble judging...
  8. Let's say SPX is implying 15% vol, but you think realized vol will be 12%. Price the butterfly at a 12 vol line and compare the difference. I wouldn't use the word "edge" here. If your short vol you are collecting risk premium.
  9. @TheBigShort

    OK, I understand - thanks for the clarification.
  10. Long time lurker on these butterfly spread threads, extremely informative. I’m still learning a ton, but using some of these techniques has really changed my trading for the better.