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Dissecting the Butterfly

Discussion in 'Options' started by Average Joe, Mar 19, 2016.

  1. Average Joe

    Average Joe Guest

    Some recurring themes that I've noticed is the idea of monitoring the legs of the butterfly to determine if an adjustment is required. How does one do that and what should one look for? I am a bit unsure as I don't intuitively see the usefulness of monitoring individual legs given that the greeks of the butterfly should reflect it. Or am I missing something?

    I'd love to hear what others have found useful and their approach in looking at individual legs.

    (I've heard Kevin Lee talked about this and most recently Chuck on the Trading Group March 8th video)
  2. vega4mike

    vega4mike Well-Known Member

    I think what Kevin is referring to is that sometimes when you look at the whole position you may not be able to easily identify the parts of your position that are no longer helping the trade & have become a theta drag. By looking at the individual legs of a fly (debit +credit spread combo), if the credit side can now be bought back for a very small price say 10c, then you may be better off buying back the credit spread & putting on another fly to get more theta into the trade or at the very least remove the risk since at this point risk reward of the credit part of the fly is no longer favourable. Looking at the positions greek, you may not be able to easily see this. At least this is how I see it.
    So its basically monitoring the debit & credit sides of the fly.
  3. Average Joe

    Average Joe Guest

    Interesting. I haven't looked in to this but wouldn't looking at the butterfly theta also give you the answer? I mean the Greeks are additive so if the short spreads are not providing the amount of theta desired, the butterflies theta should reduce proportionately.
  4. vega4mike

    vega4mike Well-Known Member

    Agreed, however, does the reduction in theta tell you anything about your risk, experienced traders may see this & immediately realise that the credit side is now carrying far too much risk & make an adjustment, by getting rid of the risk and doing whatever to bring more theta to the trade, an inexperienced trader following rules may simply add more theta to the trade, leave the risk on because they are not aware of it , get more theta into the overall position & think everything is now ok.
    If your trading a simple fly & not a fly that has morphed into a complex position (M3, Rhino, etc), then looking at your greeks may quickly reveal the risk, but for complex positions, the risk is easily hidden.
    Also be aware that the greeks as they are lie to you (calendars are long vega, etc). After all the greeks we see apart from gamma are of the 1st order, there are second order greeks which may give you more information but are generally not available in the analytics we use.
    The closer you get to expiry the more unstable the greek get. I could go on & on about the unreliability of the greeks, but its suffice to say, you need a back up to your greeks when trading complex positions so that you can quickly see where your risk is & one way is to understand the individual legs of your positions, tedious! Yes,:(
    Of course its ok to simply rely on the greeks, but once is a while that hidden risk in that spread that you failed to spot in your complex position may just sprig a surprise on you one day...:eek:
    Rick, Kevin Lee and Chuck like this.
  5. SVL

    SVL Well-Known Member

    Yesterday I watched TG 2 episode from May 26, 2015 which convinced me even more that dissecting the butterfly is crucial for bringing your trading to the next level . I think spending considerable time studying how each individual leg performs over time under various market conditions is more beneficial when a simple back-trading .
    In the same episode Curtis Allen discussed 3 ways of reducing positive delta.
    Option A : rolling upper longs up
    Option B : rolling shorts down
    Option C: rolling lower longs up
    You could watch from 0:50 to 0.55 here:

    This is how Curtis’s M3 position looked on May 26, 2015
    2016-05-26 Curtis Allen M3  RUT Jun 15.png 2016-05-26 Curtis Allen M3  RUT Jun 15 Analyze.png
    I decided to study how each way of reducing delta performed over time .
    I tweaked the ratio of each spread in order to obtain similar amount of negative deltas. The risk profile of each adjustment looks as follows:
    2015-05-26 M3 adjustment A.png
    2015-05-26 M3 adjustment B.png
    2015-05-26 M3 adjustment C.png
    After doing this study I was actually very surprised that option A ( moving upper longs up) was a better option than other two. I believe it is primarily because Option A was the only one with positive Theta and negative Vega.
    2015-05-26 Curtis Allen M3 adjustment.png
    The above study was done for a range bound market with extremely low volatility. I plan to do similar dissecting studies for rising and falling markets as well as for different DTE periods and different volatility regimes. Hopefully after that I would be able to understand why a specific adjustment is better than other alternative options in a specific market situation.
    Last edited: Apr 11, 2016
    N N, Capt Hobbes and DavidF like this.
  6. Capt Hobbes

    Capt Hobbes Well-Known Member

    An important piece of the context is the purpose of the adjustment. When you cut negative deltas on the upside of an M3, an adjustment like that will stay on for a while. On the other hand, when you reduce positive deltas on the downside of a Road Trip faced with a risk of a down move, that is just a temporary fix for a day or two. After a few days, either the danger passes or you decide to pull the plug, at least on that particular trade structure. In the first case, positive theta is pretty much a must. In the second, even outright negative position theta won't hurt as much as the "slippery slope" on the left of a BWB could.

    Curtis' adjustment seems something more of the second kind. It's not very surprising that a positive theta negative vega position did better (or less badly) over a 16-day up move. But the important questions are: 1) Would he actually keep those verticals this long in this scenario? 2) How would these adjustments compare if the down move actually played out?
  7. SVL

    SVL Well-Known Member

    Dissect or not dissect ? In my previous post I only tried to demonstrate the importance of monitoring each individual leg.
    Yes, it is a very tedious work but it is the only way to understand why some adjustment is better then another.
    Curtis Allen said that he was most likely to make the adjustment C as he was concerned that if RUT goes up, adjustment A would hurt him the most.
    Without dissecting the butterfly we would not be able see that it was not the case.
    Only after doing hundreds of similar exercises and spending countless hours, we would be able to reach the proficiency in trading complex option positions. This is the ongoing theme in many interviews of John Locke with the successful traders of the month and that particular TG 2 session on May 26, 2015.
  8. SVL

    SVL Well-Known Member

    Another excellent advice was given by Ron Bertino during TG 2 session on Apr 12, 2016 ( 0:15 to 0:22) about monitoring a broken wing butterfly as 2 individual components : a regular BF and a credit spread. Once 80 % of credit spread earned, it is time to make an adjustment.
    Last edited: Apr 16, 2016
  9. Gabor Maly

    Gabor Maly Well-Known Member

    Very interesting analysis and thanks for posting this SVL. It does make sense to test this in multiple environments, while Option A did come out well in this relatively muted "rebound", you may get different results in a scenario that Curtis in the video was afraid of which is a quick face ripping move up after a sustained move down...in that case deep ITM longs will get crushed and probably suffer more than option B or C (and the profile of A you have posted seems to be in line with that). Again to be tested, I do however at the moment try to keep my longs closer to the money once we get a sustained move down.
  10. Al G.

    Al G. Well-Known Member

    In trading the Road trip Dan/Tom reccomend "layering' the trade every two weeks. The idea is that the RTT has positive expectancy and the more of them you put on the better. I really like the concept of layering (also introdduced with space trip trade) , but in low vol environment in two weeks the original RT might not have moved much so in essence you have the short of both RT strikes relativel close to eachother.

    Can anyone share how they go about layering, can we use price moves as a guide of when to layer eg if price moves 2 ATR than put another RTT one. I would like to know what rules of thumbs other traders utilizee in their layering technique.

  11. Capt Hobbes

    Capt Hobbes Well-Known Member

    I'm not questioning the importance of detailed adjustment analysis. What I'm saying is an adjustment should be first of all viewed in the context of the problem it's intended to fix. That dictates which of its properties are more important that others. Further, it's good to begin the analysis of an adjustment by reviewing a rough theoretical model of the greeks. Individual leg monitoring is fine for revealing where real life doesn't follow the model, but without a model we might see just the trees and not the forest.

    Here is a way to look at Curtis' example.

    His first priority is to fix the delta which is too positive so a continued move down could hurt. This is a stopgap solution until it becomes clear what's really happening. He is considering rolling up the upper or the lower longs, or rolling down the shorts. All of those are different names for the same thing, adding a bearish vertical. The only difference is its position relative to the money. We want to compare what these three different verticals add to the existing structure (so strictly speaking, we are not dissecting anything).

    Here are greek profiles of a bearish vertical with 33 DTE, not quite the same as the example, but good enough for a ballpark understanding. The spread is 10 points wide, but the general shape for a 20-point one is not very different. It's helpful instead of showing three curves for three locations of the vertical to show just one curve with the position of the market relative to the spread marked with letters A through C. I erased price labels to make it less confusing. Gridlines mark roughly 1% moves, and the two vertical dotted lines show where the strikes are. With adjustment A the market is about 4% below the lower strike, with B it's about 1% above the upper strike, etc.


    Immediately we see that adjustment A is very different from B and C in terms of delta, because the market is on the opposite sides of the dip in the curve. Which means even if the initial adjustment delta is the same, as the market moves down adjustment A will pump less negative delta into the position, while B and C will pump more, and vice versa. Clearly, for our purposes it's better if the added negative delta increases as the market moves down and decreases as it moves up, which makes B and C superior to A. (All of which in a long way of saying that the gamma of A is negative and of B and C is positive, and adding some positive gamma to the original position's negative gamma is good). Comparing B and C, we can also say that C maintains this desirable property of positive gamma (downward slope going left) over a wider range on the downside, and B does so on the upside (upward slope going right). So overall, from just the delta viewpoint both B and C should give us a flatter t+0 line than A, and C will do better for a continued move down, while B will be slightly better for a reversal up.


    Theta is not important for our stopgap adjustment. However, the theta graph certainly explains the difference in behavior over a longer holding period. For a longer period, it's important to keep in mind that these curves morph with time and IV. The curve above would suggest that for adjustment C a 2% (2 gridlines) move up would change the theta from negative to more negative. However, in SVL's study that move plays out from 26 to 7 DTE. Over that time the curve contracts a lot along the X axis, so we should expect theta to go more negative and then less negative, which is what the study shows.


    The vega graph again shows that A is pretty much the opposite of B and C. Again, if more downside is our worry, then an increase in volatility probably goes along with it. For that scenario, the greater positive vega added by C is a plus.

    Again, these are just general illustrations, far from any sort of precision. But hopefully they make it pretty clear what in general to expect from each of the alternatives, before even collecting any data.
    Last edited: Apr 17, 2016
    Marcas, Luke, N N and 4 others like this.
  12. Luke

    Luke Well-Known Member

    Bumping this thread up because of the great information and it may help some of the newer traders. As regards the M3 discussed, I take it that the low vol environment makes this trade lose some of its edge?
  13. Gabor Maly

    Gabor Maly Well-Known Member

    Good question and I am getting your point. A question in return however, what neutral income type options trade does not "lose its edge" in the current environment? I hope you won't say RTT because its returns are less compared to a more "healthy" environment, nor 60-40-20, etc.......so what performs at the same level or better?
  14. Luke

    Luke Well-Known Member

    I'm too new to really know the answer to that, but I'd say as long as we are net sellers of premium, especially puts, than all trades will bring in less premium and only long Vega trades will do better? Other than that, making sure the trade has upside protection against a grinding up trade and protection in case of a 50-100 point drop seems to be the only way to work income trades.

    In regards to an M3 type of trade, is that why many of the income traders have moved away from this (or at least less talk of it on this forum)?
  15. Kevin Lee

    Kevin Lee Well-Known Member

    Let me share what I know about M3 vs BWB style trades. Low vol is painful for most if not all vega negative trades, but not all the trades are structured the same. Therefore, some will suffer more than others. M3 appears to be more difficult than RTT (or other BWB variants) for two main reasons in my opinion :

    1. As market grinds up and IV melts down, IV skew becomes steeper by the day. M3 usually has its right leg on the higher strikes compared to RTT. Therefore, that M3 right long leg suffers more IV crush as the skew steepens. M3 traders will likely experience this ... day after day, the M3 T+0 tends to keep slopping down more and more as market grinds up or just stay unchanged. M3 delta will keep becoming more and more negative. You just adjusted it yesterday and what happened today ? The T+0 line slopes down again. You keep having to flatten it. That's the effect of a steepening IV skew.

    RTT's T+0, on the other hand, is much more robust on the upside. The main reason is the steepening of skew is more advantageous to BWB compared to a regular butterfly. You can view BWB as equivalent to a regular butterfly + a bullish Put vertical spread. As skew steepens, the short IV of the vertical spread will fall more than the long IV.

    2. RTT can be traded in such a way that there is no more risk on the upside. Therefore, it doesn't matter how far market runs up, there isn't much to do and you don't lose. But that's not the same for M3. There is a zone on the right side of the M3 butterfly where the trade is vulnerable. Yes, if market really runs up a lot very quickly. M3 can become a delta positive and gamma positive trade. But that's a different story. More often than not, you're forced to adjust the M3 structure upwards.

    In the past many months (I think since last year's election), market has been going up. Therefore, BWB type of trades are expected to do better than M3. Of course, if you keep pushing the M3 butterfly up aggressively along with the market, I guess you'll do pretty well too but that's assuming you know in advance market will continue to be bullish.

    Having said all that, I'm not saying that BWB is a better trade than M3. I'm just saying BWB is an easier trade in current market condition. But when market condition changes, different trade structures will be in play again.

    I hope I'm making sense.... :)
    CC, Steph, Chaitanya and 4 others like this.
  16. SVL

    SVL Well-Known Member

    Please keep in mind that the low volatility in a fast rising market ( like in 2013) and in a sideways market ( like in 2017) are completely 2 different environments .
    Between Dec 2016 and July 2017 RUT has been in a very tight range between 1340-1440 and this is almost ideal environment for any ATM trades as the market stayed inside the tent most of the time.
    Between Dec 2012 and July 2013 RUT went up from 820 to 1060 ( almost 25 % ) and it was the most hostile environment for any ATM trades as you had constantly to roll up and RUT kept moving outside the tent.
    As far as there is less talk about M3 on Capital Discussions recently , please keep in mind that Capital Discussions is still the option’s education site and there is a natural tendency to promote its own alert services ( RTT, Kevlar, etc). If you go to John Locke’s site, there is a lot of talk about M3, Bearish Butterfly, Rock and much less about RTT, Kevlar .
    Road Trip Trade and Roll Baby Roll Trade were introduced to Capital Discussions members at about the same time in Nov 2015. RTT got all the fame and became the signature trade for many Capital Discussions members while nobody ever talks about the Roll Baby Roll trade presented by Tom Hughes.
    Why, because RTT has been heavily promoted and RBR was not.
    Nevertheless, Roll Baby Roll is a very robust ATM trade which is absolutely free for Capital Discussions members and which will outperform any OTM trade in most of market environments by a mile.
  17. Luke

    Luke Well-Known Member

    @Kevin Lee Yes, that makes sense and it is helpful. I also appreciated your M3 vs BWB video, so I should watch it again.
    @SVL That makes a lot of sense in both regards. RBR is not something I've heard about or read until just now, but I will check it out, if nothing else than to keep learning. I had been doing another ATM trade, but I've stopped because I keep thinking we've got to pull back, or at least move out of a tight range and start seeing some larger moves.
  18. Trader G

    Trader G Well-Known Member

    Do you still trade this? I remember backtesting that trade a couple of years ago after watching it at an SMB presentation and it seemed to get in trouble like a lot of ATM trades when price movement started to pick up especially on the upside. I would be interested to know how results have been on this move up over the last year or two.
  19. SVL

    SVL Well-Known Member

    I do not trade anyone’s trades any longer with the set rigid guidelines but rather use the elements and key principles of M3, RBR, etc.
    Now it is more free style ATM structures either broken wing butterfly/broken wing condor structures , sometimes hedged with a DIMC and sometimes not . The main focus is on keeping T+0 line flat.
    I was fortunate enough to join John Locke’s Community Coaching program in June 2016 when he introduced Broken Wing Butterfly Master Track series which helped me tremendously to understand the plusses and minuses of different broken wing configurations. Please see attached the trading journal of my 2 RUT trades for July 2017 expiration to better understand what I mean.

    Attached Files:

  20. DavidF

    DavidF Well-Known Member

    Thanks for sharing SVL, good to see a trade that didn´t just float in a range. In the initial set-up it looks like you´re vulnerable to an up-move, do you just accept the risk? I´m used to trading a flatter t-0 line but the flip side of that is that I´ve become more of an expert in not losing money as opposed to bigger gains. Agree Tom Hughes stuff was very good, have used his principles extensively. As far as I remember it was a downside hedge for his M3 trade but is an excellent stand alone trade.

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