I had been pricing November butterflies for several days the end of last week and the beginning of this week. November was going to be the month I increased my preferred butterfly trade by another three contracts. On the morning of Tuesday, September 25, I saw an opportunity to buy my November butterflies for what I had determined would be a good price. I put the order in below the mid and was lucky enough to get a good fill. Although perhaps I should wait until this trade is closed before I determine whether that was a lucky event?
I start my butterflies with the middle, sold strike below the market and add in-the-money calls to flatten out upside risk. I did something else that I always do lately. I immediately bought an extra long out-of-the-money put position.
Why is buying an out-of-the-money something I regularly do, particularly since the butterflies, the profit engine of this combination trade are already bearish by nature of where I start them? Probability or just plain conjecture tells us that when implied volatilities are at levels from which they typically reverse, they're more likely to go up than down. Volatility measures have definitely been at levels from which they usually reverse upward. That didn't mean that they would this time, as we well know from these long months of markets grinding upward while volatility levels stay low. I've been buying those extra out-of-the-money puts for a long time, subsidizing someone else's profits. However, we're talking about probabilities.
Usually implied volatilities rise when equities are rolling lower. Traders and investors are scrambling to buy options, often out-of-the-money puts. With more demand, their price goes up as implied volatilities are rolled upward.
A butterfly position tends to be hurt when implied volatilities expand. So does an iron condor. For those who like to think in terms of the Greeks of a trade, both types of trades are negative vega trades. Vega measures how much a trade's value will change with each 1-unit change in implied volatilities. When the vega is negative, the trade is hurt by that much when vega rises. So, I'm trying to protect my trade against volatility changes as much as I am against price changes. In the beginning, at least, the volatility risk is the bigger risk unless prices change hugely.
Long puts and calls are positive vega positions. Adding them to a trade such as an iron condor or butterfly raises the vega. It's not quite so negative. The position isn't hurt as much by a rise in implied volatilities. Since a rise usually occurs in occurrence with a drop in prices, it makes more sense to buy the put than the call.
Therefore I dutifully bought an extra RUT NOV 780 put as soon my butterfly trade had filled. The put was out of the money, of course. I spent $4.90 for the single extra contract I bought.
By the end of the next day, the RUT had dropped more than three standard deviations from the point at which I had entered my trade. That's a big move. Implied volatilities had risen. My butterfly trade, however, was theoretically down only $89.99, including commission costs to enter and exit the trade. In other words, the options themselves were profitable: the trade just hadnâ€™t quite made back the cost of the commissions.
However, without that extra long option, the trade would have been down $350.01. The extra long option, now worth $9.30, had made the difference.
Would that single extra long put have protected my position from all losses if the RUT had kept barreling lower that day or the next day? No, but it served its purpose, which was a dual one for me. It stabilized the trade long enough for me to make calm decisions about whether the trade needed adjustment. It served as Armageddon insurance, so that if Wednesday morning's drop had been a jaw-dropping one, I would not have lost all the money invested in the trade. At some point, that extra long would have meant that the profit-and-loss curve turned up again as prices went lower.
I don't anticipate financial Armageddon. If I really feared that, I would be buying gold bars and not trading options. However, having placed a 60-contract SPX iron condor trade the day before the Flash Crash, I've been close enough that I want protection. Having that insurance allows me to sleep at night. Furthermore, it allows me to trade month after month, and even to increase the size of my trades as I think appropriate.
There are always a pro and a con to each decision you make as an options trader. What's the con to buying that extra insurance? Most months, my profit is reduced by the amount I spent on that insurance. Just two months earlier, my trade had been a losing one. The money lost had been almost exactly what I had spent on my Armageddon put position, my insurance, as some term it. When I used to trade iron condors, I knew how much insurance I could afford to buy, but I am still in the process of backtesting various insurance levels on the butterfly trade. I had paid too much for that insurance that month, and the RUT had taken off to the upside rather than the downside.
Why not just wait until the Armageddon insurance is needed before buying it? Wednesday morning, shortly after the open, the implied volatility of that 780 put had risen 4.7 percent. It was priced at $8.15, already up considerably from the $4.90 price that I had paid, and not far from its $9.30 price at the end of that day. Buying it then wouldn't have benefited the trade as much.
If stabilization is needed after a move has already begun, buying a debit spread sometimes tempers the expense of buying vega positive. The option you're selling as part of the spread is usually expensive, too! In the middle of the week, I wasn't sure the tempering worked as well as it might otherwise work. For example, the -830 put/+780 put portion of the butterfly cost $8.46 when first entered. However, that spread was worth $14.35 near the end of that next day, Wednesday of this week, when a trader might have been making a decision about whether to hedge risk before the close. The next morning, Thursday morning, when the RUT steadied and began to rise, the price of that spread was dropping fast again. I noticed the mid at under $11.00 by soon after the open. That typical protection from too-expensive options that a spread offers was perhaps not working as well as it might other times.
I thought you might appreciate some real-life examples taken from a live trade. Because each trade varies so much in size and other parameters and because each trader has such differing needs from insurance, there are no specifics I can give you about what kind of protection you need or don't need for your own trades. Most traders I know who trade similarly to my kind of trade rely on the trade's setup and the low probability of another Flash Crash or financial Armageddon rather than insurance puts. There are pros and cons to each decision.
I wanted to spend a few moments addressing the current situation before I close. If you've been reading my Monday Wraps, you know that I believed it was time for the indices to pull back through rising regression channels. Prices zigzag through those channels, even when the channels are still climbing. It was time for them to zag. After a first sharp drop, it's normal to have a relief rally. We don't know how far or how long a relief rally will go, but it remains possible that prices could either retest recent highs or, after a period of rallying, roll down further through those rising regression or price channels.
So, what do you do today? You don't panic and overspend on anything. You realize that when you back-tested or paper traded your trades (You did do this, right?), you weren't paying attention to economic developments across the globe. You take a breath.
Then you honestly evaluate whether you have too much risk going into this weekend. We've just had the results of the stress tests on Spanish banks, which, on first blush, markets perceived as reassuring. That could change by Monday morning, of course. As I type this, we've also just seen the results of the Chicago PMI, with that number in contraction zone. That's not good, although equity markets appear to have shaken that worry off as I type. That could change by Monday morning, too.
Your choices are to keep your trade as is, reduce the size of your trade, or perhaps hedge in some manner. Don't over-hedge out of fear, however, because you then are subjecting your trade to bigger losses if markets decide to rally next week.