The other day, I was setting up a type of RUT butterfly that builds on the work done by a trader named John Locke, and I wanted to smooth out the deltas. For newbies, delta measures how much the price of an option or an entire option position is expected to change with a one-point change in the underlying. As many of you know, butterflies tend to be negative delta as they're established.
I was setting up a bearish butterfly, so the delta was even more negative than usual. I was going to buy a long call position to even out my delta. I could have bought an out-of-the-money (OTM) RUT call, or I could have bought a deep-in-the-money (DITM) IWM call. Since I had only three butterflies (3-6-3 contracts) in the RUT, a DITM RUT call would have overwhelmed the position, and the IWM can be considered a mini-RUT position for this purpose. I could name pros and cons to either of those choices, but the reason I ended up choosing the IWM position was that a DITM call acts like a stock substitute. It is an option's extrinsic value that's impacted by the changing volatilities, and DITM options have less extrinsic value than an at-the-money (ATM) option or many OTM options. That's especially true when I compared a DITM IWM call versus an OTM RUT one. The IWM call I ended up buying had only $0.145 extrinsic value. If implied volatilities dropped heavily, my call wasn't going to lose much money from the vol crush.
How does one know which IWM call to choose and how many to buy to hedge a RUT butterfly position? First, I want to have a call with a delta as close to 1.00 as possible, probably near 0.90. Such an option would not be impacted as much by fluctuations in volatility. It would respond quickly to changes in price. In Options as a Strategic Investment, Lawrence McMillan suggests "something approaching 0.90 [in delta] or higher" if you want a stock substitute (102). This helps keep the "today" line in a profit-and-loss or analyze graph from sagging to the upside as time passes and expiration approaches, although that today line will eventually conform to the expiration graph, of course.
Figuring out how many to buy will require some skill with beta weighting. McMillan defines "beta" as "a measure of how a stock's movement correlates to the movement of the entire stock market" (964). A high-beta stock would be one that tended to move more than the stock market tends to move. For example, the site FINVIZ assigns a beta weighting of 1.46 to Dupont (DD), suggesting that DD has been moving more than the market in general.
However, it's possible to use beta a different way. You can beta weight one stock or option against another underlying. You can weight a whole portfolio of options against one stock or index. I could beta weight a RUT butterfly plus IWM call position against the RUT, for example, and figure out how many IWM calls I needed in order to smooth out the today line the way I wanted to smooth it.
Here's how, with the bearish RUT butterfly pictured first. Note: the three-contract butterfly filled as two separate orders, one a one-lot and the other a two-lot. Please remember that my articles are roughed out ahead of time, and so charts and underlying price are not current.
Bearish RUT Butterfly:
Sizing requirements mean that the graph and order information are scrunched together, but you can see under the "Live" line underneath the graph that the position delta is -28.73.
I wanted a higher delta position, or, phrased differently since some people have difficulty with "higher" and "lower" with negative numbers, a less negative one. Using the beta weighting feature on think-or-swim and a bit of trial and error, I chose 2 DITM IWM FEB12 60 calls that would flatten the white today line in the graph and also raise the delta, making it less negative.
Beta-Weighted RUT plus IWM Position:
Beta weighting the position allowed me to flatten the risk to the upside in case the RUT gapped and ran up to 790-800 in short order, and kept losses manageable if it instead gapped and fell to 710-712 before I could adjust the position. My profit-and-loss line was going to remain manageable over the next 40-50 points either direction.
Beta weighting comes in handy, then, in times when you might want to hedge an SPX position with SPY options or a RUT position with IWM options. It can also be helpful to beta weight an entire portfolio, to determine from the Greeks of the position how the entire portfolio might perform under certain market conditions, and how the risks might be hedged.
Not all brokerages or charting programs allow beta weighting of simulated positions before they're added, but if your brokerage offers this capability, it can help you plan your trades and your adjustments.