We know the gamma, theta, and Vega of a butterfly is trimodal (assuming short guts ATM). My question is how does one determine where to price strike the wings in relation to the body? The vol surface, skew, Kurtosis play a role (asymmetric wings), but I’m still not clear on how to structure my fly’s. I’m sure it would help if I had a model or heuristic sense to determine if the ATM straddle is trading above fair value, and the OTM strangle is below fair value?
“Mispricing” to me is an interesting concept. You have the current price which is, and you have an outlook that says “What should be”. Philosophically, a decision to buy an ATM butterfly implies you believe prices until expiration will stay within one standard deviation of the current price, otherwise a different strategy would be better. So the apparent mispricing is the market’s outlook on volatility, right? Buying an ATM Butterfly is saying you believe realized volatility will be lower. What are some sound reasons for believing volatility will contract? Volatility is currently high by hisorical measures and is mean reverting? You perceive change in the risk environmenr which has yet to be fully reflected in current volatility levels? Is there a technical analysis edge concerning volatility? Is the trade idea based on the historical edge of realized volatility being less than implied volatility as compensation for those holding negative gamma positions? To me, a truly useful market mispricing is where you can structure a trade that has no or almost no risk that offers competitive rates of returns. A position that where you can obtain “free” or “subsidized” positive gamma that you may partially hedge or not. For example, if bullish, a long ES risk reversal takes advantage of skew and may provide a reliable edge. Partially hedged long OTM directional butterflys in ES puts also appears to provide an edge. Obviously, moneyness, volatility, and skew changes will affect the potential profitability of trades like these, but that can be modeled. For markets like we are experiencing now, overnight or especially intraday gamma scalping off OTM ES butterfly puts can provide reliably high reward to risk ratios, which brings up the question of trading intraday and overnight edges. If I were better at math, perhaps I could write a proof of concept. Maybe when I leave trucking. Grin.
well aware of the pitchfork. I've read Dest's threads, and also read Doobs paper (which he swagger jacked Dest' IP) Several ways of viewing vol, disentangling three main movements of the smile (ATMStraddle, 25D risk-reversal, Vega-weighted FLY). 25DRR gives us info on the skew directionally. BFLY'z gives us info on the convexity of the smile. Thus an astute speculator can price fly's throughout the term structure to get a feel for the surface. Once armed with this arsenal, he can then strike price the wings efficiently. Sounds good on paper, much harder in real-time action!
I recall that Destriero usually sets his wings very wide, almost to the point where he is paying no extrinsic value. I suppose one could do the same with an iron condor, but perhaps a small advantage often presents itself in microstructure with butterflys? When these strategies are combined with an outlook of declining volatility, such as where the underlying is in relation to its earnings cycle, it would be reasonable to assume it would be a trade that has above average expectancy. As far as money management, I wonder what is optimal? Is it modest position sizing with no stop, 1 standard deviation, or a test of one of the wings? Is there a time to expiration consideration when it comes to optimal money management? Going to run some flys/iron condors through an option pricing simulator to see how it looks: http://opcalc.com/dSf Note, on the above pricing simulation, maximum loss is not shown. I have only shown the points where theta becomes negative. I assume this site’s option pricing model does not consider typically correlated changes in IV as prices move, which is obviously another consideration when deciding to use money management. So perhaps that is it, using a stop if theta becomes negative may be optimal. It is probably best practices to run a scenario where a big price move is combined with a big jump in IV to see if you are comfortable with that kind of heat. Edit: The wings depicted on this simulator pay little extrinsic value.
Perhaps you have some irons in the fire, but why not just open an (even unfunded) account in TD (for the Thinkorswim platform) and use their very advanced option pricing modeling and analysis..
Irons in the fire? I have a funded IB account. Do you have an opinion of their options analytics versus TD?
No ill intended here. I have no working knowledge of the IB, but I been using TOS for many years...In any case, since you can get access to it at no cost, you might want to compare the two yourself (also, I bet ET has a lot postings dealing with comparisons...)