My Bread and Butter Trade

[ernsttanaka]

To celebrate this new forum I will post for a month my main bread and butter option trade. For several years I have been trading ATM Butterflies on the Russell 2000. A butterfly is a typical non-directional trade, which allows a trader to accept market risk without expressing a strong bias for a direction. The reward for this trade comes out the decay of the short options.

For July I opened my trade today, by selling a ATM (Iron) Butterfly (770/820/870) for 34.65.
I will publish my trade in a 5 lot - this is a good size to communicate all the aspects of this trade - for reason of privacy I will not disclose the size in which I trade in real life.

The July trade has a risk of 5*100*50 = $25000 minus the premium received $17325, so my total risk is $7675. This the beauty of the trade my risk is defined - an overnight gap and the RUT open on 0 or on 2000. My risk is defined. I will try to work this trade till I earned approx 20% of my risk.
In normal months I might have to adjust this trade a couple of times. Sometimes it is set and forget and at times I will have to bail take my loss and wait for the next month to start again. For me it is essential not lose more than MAX!!! twice what I make in a normal month. But a loss of twice a normal month should be a very exception hit - IMO a combination of personal errors and a though market can only lead to that kind of loss.

So we got the entry, we talked about Risk, we talked about a goal for reward. I will update daily and walk you through the other aspects of this trade.

I know we have some very knowledgeable options traders on this board; Harold, Thannis, Michael. Feel free to chime in as we move along. I am very interested to learn from you insights.


Happy trading

Ernst

[so2c]

thanks for sharing your experience and looking forward to following and learning from this trade!!

my question at this point would be what's the rule for selecting the border numbers in this case are 770 and 870? (from the charts, looks 870 --> recent top and 770 in Apr--> recent low in Jan).

Also, is there a best entry point, e.g, waiting until RUT comes around middle of two borders (in this case, (870 - 770)/2 + 770 = 830) or when its premium increased? .

I would also like to know additional selecting conditions for iron-butterfly trading candidates, e.g., do we need to find high/high liquidity volatile securities? positioning or avoiding for ERs ? etc.

Thanks!

PX

[ernsttanaka]

For a option trader, Friday was a unique day; market "hard" down and no move in the VIX. I will show in a minute how that worked out for my trade. But lets start with a basic introduction of the page I copy from my broker platform (ThinkorSwim), since not everyone is with TOS and not everyone trade options on a daily basis.

The page I copy, in this post, is the analyze page. This page is built up in three section. The top section shows the Profit and Loss graph. The middle section shows my position risk expressed in terms of option Greeks. The bottom part show you which options are part of my position.

The P/L section shows the Profit/loss graph for expiration day in red and for the current day (t0) in white.
Tos allows to do "what if" games with the analyze page; what would happen to the graph and P/L if the volatility moves up with x points. What happens when we move time a couple of days. Or combination of those two. At the end of the day just before the close I will run through a couple of those scenarios just to see how my position (in theory) will hold up the next day. If necessary I will make a minor adjustment to compensate for a market running to close to the edge (the expiration Break Evens).

The middle section show the options greeks for today for the current price (live) and if the market would move 1sd up or down. I am going to be brief on greeks, if you need more do a search on Google. In short; Delta and Gamma is the directional risk. Vega is my risk associated with a moving Implied Volatily and Theta is the estimated time decay of one day. Theta is my daily pay check. Today my vega is -304 which says that if the RUT IV moves one point up. I loss $304 and if the RUT IV moves one point down, I will make $304.

Today my delta is -3 which is extremely "flat" no directional risk. Yesterday the delta was -22 which means for every RUT point we go down. I make $22. Gamma is a factor which expresses how the delta of the position is changing. Yesterday the gamma was 1.18. This means in short and with a broad brush. That for the first RUT point down I made $22. For the next rut point down I made $22-1.18. For the 3rd RUT point down I made $22-1.18-1.18. Etc etc. This continues till the delta isn't short anymore and then I will lose the delta in $ per point if we continue down. Gamma is not a stable number it will increase over time and as you see today it also increase when we get closer to the edge of the trade. It is Gamma which makes the T0 graph have a slope.

Today was unique because we went down and the IV was flat. Since I started with a negative delta position and a negative vega position. I gained the "delta profit" and was not punished for an increase in IV. This doesn't happen often but it is the 2nd time this year.

Lets finish up for today with the questions from Px;

1. my question at this point would be what's the rule for selecting the border numbers in this case are 770 and 870? (from the charts, looks 870 --> recent top and 770 in Apr--> recent low in Jan).

2. Also, is there a best entry point, e.g, waiting until RUT comes around middle of two borders (in this case, (870 - 770)/2 + 770 = 830) or when its premium increased? .

3. I would also like to know additional selecting conditions for iron-butterfly trading candidates, e.g., do we need to find high/high liquidity volatile securities? positioning or avoiding for ERs ? etc.

1. I like to look at current ATM implied volatility for the RUT and calculate what the expected move for the RUT is till expiration. Current 42 point up or down. Then I will round up to the next strike. Since this trade only to be active for approx 15-20 days, 50 wide should give me a reasonable safety margin. (Plus there is a plan if we have bigger moves).

2. With hindsight there is of course a optimum entry point. I look for an entry point in the range of 45-30 days before expiration. And as a personal style I like to enter when I (think to) see an intermediate top in a confirmed uptrend. It is not that you can't trade these in other markets - and if I don't find my favorite spot I will enter just based on time. This with the exception when the VIX signals market panic, then I will wait till I see a confirmed downward trend in the vix.

3. Highly liquid, multiple exchanges, electronically traded, broad based indexes. For this "bread and butter" kind of trade only the RUT and NDX count. The spx is open outcry, good to trade in normal market conditions, but during panic hours the SPX pit will not see my complex order and I will get run over by GS and MS. The SOX is not liquid enough and trades only on PhlX, nothing against PHLX, but if one echange has the monopoly of the option price you will see strange things during hours of panic. The rest of the broad based index are disqualified (for me) for similar reasons. For this style of trade I stay away from individual stocks, because I am not interested in carrying the risk of a merger or naked-photo of the CEO on his twitter account.

This is it for the weekend, as said before come out of hiding if you have questions. BTW I am Dutch (and live in NY) so excuse my grammar. I don't have time to reread it tonight, I will correct the most obvious errors tomorrow.

[nickola.pazderic]

I'm very glad you have taken the risk to show and explain your bread and butter trade.

[Pascal]

Thank you for posting your option trade Ernst.

This is very useful for those like me who do not trade options very much.


Pascal

[senco]

Ernst, thank you for sharing this; great opportunity to learn :-)

Could you please clarify regarding your money management:
> I will try to work this trade till I earned approx 20% of my risk.
> For me it is essential not lose more than MAX!!! twice what I make in a normal month.
Is the intention to exit the trade when the profit reaches a target if 20% of $7675 , and bail out when in spite of adjustments one is at a lost of twice as much?

[Ken]

Hi Ernst,

Base on the setup, as long as price remains inside the triangle, the position will result in net profit by option expiration. What do you find to be the best approach for exiting the position when price starts to move outside the triangle ? Do you just exit all legs of the trade or try to neutralize the total position delta as close to zero as possible until expiration ?

Thanks-
Ken

[ernsttanaka]

A rotten day for the market and the butterfly gave back a little from Friday's gain.

The position Greeks are within my comfort zone. 32 Delta's long, 2 Gamma's long, Theta of 59 and a vega of 270. A one day, one standard deviation move for the RUT is approx 10 point and a 2SD day is 20 points. So if tomorrow again a down day, we can expect to end in between 32+(10*gamma) and 32+20*(gamma). This is a very rough calculation since gamma is not static and increases when we move to the lower Break even point. For a position this size I start "worrying" about the directional-greeks (delta and gamma) when I get close to 200D long or short. The above rough calculation, with all it errors, shows that in normal circumstance I should be able to sit on my hands. (which can be difficult enough by itself).

The Implied Volatility - burned into my screen by monitoring the vix continuously - is still not signalling a big break in the market. This the main reason I have not (yet) hedge the RUT vega's with a time spread in the RUT. I do have some time spread in other vehicles. So on a portfolio level I have a (small) hedge against the short RUT vega's.
An other reason I haven't hedge the short vega's has to do with the "vertical volatility skew". I leave that topic for now, you can give it some thought, I will get back to that tomorrow.

I close for today by answering the outstanding questions.

Senco -- that is a good summary of my trade-plan. But don't forget that I said twice my profit potential only in situation of severe market stress and personal errors. With an ATM butterfly on the indexes I "play" the odds that this month will show a normal distribution. This is one of things I monitor by checking how big the daily moves are in terms of Standard Deviation. Another thing I monitor is the VIX. If the combination is showing that my axiom proofs to be false then I bail, take my loss and wait for the next month. My experience is that a "normal' loss in a month were it just doesn't work, is closer to 1 times a normal months profit.

BTW my personal errors in this regards are over-trading, anticipating a market direction and not obeying my max loss rules. When you are doing this for several years in the end you will have seen them all :(

Ken, I am kind of hoping not to show you that this month :).
One line of defense is that my initial position is only half of the money I am willing to put at risk. So if we move closer to a break-even - I will contemplate to add an extra ATM butterfly. Another action could be taking of step by step the 770-820 spreads. This reduces the downside risk and normalizes the position greeks. I am more inclined to do the first (adding) when me move to the upside break-even and the latter when we move to the downside break-even.

[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.