My Bread and Butter Trade

[ernsttanaka]

Not much changed in the condition of the trade. I am a bit worried about market action. In the bounce I would have liked to see a bigger spike down in the VIX and of course I could have done without the sell off in the last 30min. All in all the bounce looks suspect.

Getting back to Vertical Volatility Skew and how it affects a butterfly. Attached is the current July RUT SKEW. I will do my best to clarify - it is quite advanced and it took me awhile to figure it out.

Step by step;
- the short vega in my position are coming from the short calls and puts. The long calls and puts have a positive vega but not enough to compensate for the short vega of the short contracts. Hence a overall short vega position.
- So the worry for being short vega in this position needs to concentrate on the short contracts. The long contracts will help me compensate for a increase in IV.
- When the market drops. The skew graph in its entirely is moved upwards, but at the same time moved left because a new point has become at-the-money. Hence my 820 contracts slide down the slope. These two moves, upward and slide, compensate each other at first. Only when the increase in IV is extreme the slide will not be enough to compensate.

All of this is not enough to be casual about the negative Vega in this position. A trader needs to be aware skew-development during the trade and will need to partly off-set (hedge) his short vegas with a time spread. But a full hedge of butterfly vega would be overdone.

I deal with IV on a portfolio level. One of the trades I have is a long SPY Jan13 135 puts rolled from a prior year JAN12 125puts. This position cost me some money but it is a insurance against an overnight drop. Against these puts I will sell front month puts with a delta, using my directional skills to determine timing. Currently I have sold the JUN121 puts for 50ct. I am doing this frequent and reduce the cost of the insurance.

BTW IV Skew is copied from Livevolpro TM

[haroldklee]

I can confirm that the RUT Butterfly trade Ernst is describing is a versatile and robust one. I've seen him trade it with excellent results over recent years, and have learned a lot from his observations.

As one can see, there's a lot to keep in mind. The Greeks are vitally important, especially Vega, Delta, and Theta, and it's difficult to pick up the intricacies without serious study and experience. This way of trading is an interesting contrast to what's primarily discussed here at Effective Volume. In trading the Robot, for example, most of the intelligence is applied to setting up and calibrating the entry; once in the trade, stops simplify the exit. With this RUT Butterfly, on the other hand, some thought must go into the entry, but most of the skill and analysis occurs afterwards, in making adjustments, offsetting with other simultaneous trades, etc.

I think there can be a profitable synergy in combining the two approaches. Knowing the direction of the market is a great advantage, whether in trading ETFs or options, but this RUT Butterfly allows one to profit from normal retracements and periods of choppiness. With luck, we may see how this is so this month as Ernst describes his trade.