I've occasionally mentioned beta weighting my trades. I wrote an article about beta weighting back in January of this year, for example. Some of you will already know far more about beta weighting than I can pretend to know. Others of you have no idea what the term means.

Let's take a look at how beta weighting works first. Let's go back in time to May 15, and imagine that I want to set up an SPX butterfly. I did not actually set up a butterfly on that day, so these considerations are theoretical as are the prices.

Because of all the concerns about the Eurozone on that day, imagine that I'd like to set it up a little bearish. I choose a central strike for my butterflies at 1290 rather than at the money. Imagine that I decide to place a butterfly order that does the following: sells 6 JUN 1290 puts, buys 3 JUN 1230 puts, and buys 3 JUN 1350 puts. This forms my imagined three-contract all-put butterfly.

Expiration Chart for Theoretical All-Put SPX Butterfly:

Notice that the current price is close to the upside breakeven if I set it up this way. The white T+0 line shows theoretical profit and loss that day. That T+0 line indicates that the trade will perform well if there's an immediate pullback. However, that white line slopes down quite strongly if prices climb much above the upside expiration breakeven. What am I going to do about that?

I could buy an extra call. However, because I have only three butterflies, it's hard to find an SPX call that wouldn't overwhelm the butterfly. Through trial and error, I find that a JUN 1390 call straightens out the white T+0 line nicely.

Expiration Chart for All-Put SPX Butterfly with Extra Call:

That actually looks pretty nice, doesn't it? Over the short-term, the white line indicates that losses won't accumulate too much if the SPX zooms higher. That's reflected in the difference in the delta value for this setup when compared to the straight butterfly trade. There's still plenty of profit potential. The trade still benefits from a pullback, too.

Aha, though. There's a little phrase in that paragraph that's important: over the short term. The problem is that the JUN 1390 option is far out of the money. All its value is extrinsic value, and it's the extrinsic value that's most impacted by any change in implied volatilities. What tends to happen to implied volatilities when markets steady and climb after a period of declining? The implied volatilities tend to drop, and so does the portion of an option's price that's extrinsic value. That means that my extra call option isn't going to be as helpful as it looks as if it is here.

Think-or-swim allows traders to plot lines according to changes in implied volatility. If I lower the implied volatilities in three-percentage-point steps, we can then view a plot of how the trade would perform at various price and volatility points.

Trade with Vol Steps:

We can follow the red line, showing us what would happen if the implied volatilities fell from 22.03 percent to 17.03 percent. We can tell that if the SPX were to climb to some higher number, perhaps 1350, the losses would be much greater at the red line's intersection with 1350 than it would have been at the white line's. The difference is a loss of $311.69 at the white line versus $762.99 at the red.

Several options are being impacted, but it's clear that the OTM 1390 call isn't doing the job as well as hoped or even as suggested on the original T+0 line. I need a call with as little extrinsic value as possible. Such a call wouldn't be impacted as much by dropping implied volatilities if the SPX's price climbed. I need a deep in-the-money option in this case, so deep that it has little extrinsic value left to be impacted. It needs to act as a stock surrogate. Some experts suggest that we buy options with deltas of at least .70 (or 70, if your quote source applies the 100 multiplier). An SPX JUN call with a delta of .70 was the JUN 1290 on that day, and it still had extrinsic value of $15.89! Whew. That's quite a bit of extrinsic value to be impacted by falling volatilities.

Plus, one look at the chart tells us this would just be a ridiculous choice. One doesn't have to be an expert on the Greeks of a trade to look at that white T+0 line and know that someone who fears a rollover in the markets wouldn't want that call!

Choosing an ITM SPX Long Call:

The conclusion? An SPX call just isn't going to be the right solution if I want a deep ITM option that will act as a stock surrogate. I have to turn to something else. SPY options come to mind. But how do I know which SPY option and how many of them I need? We're trying to hedge apples with oranges.

Beta-weighting the trade offers us a way to do this. Next week, we'll continue.