Float Like a Butterfly

Mean-Reversion trading is in essence dip-buying. We attempt to buy overreaction or provide in short term liquidity deficiencies. The largest risk is obviously getting in too early or getting completely steam rolled in a trade. Additionally there is a large temptation to martingale into large dips.

The options market offers an interesting way to play the dip buying game while controlling your risks and still offering large gains. A directional butterfly trade is one idea I’d like to examine and propose. In essence a butterfly is a bull spread combined with a bear spread with equal short strikes. A google search will yield hundreds of posts on trading bfly’s neutral, i.e. betting on the price staying within a defined range. New options traders, and those crazy newsletter writers, will pontificate on Iron Condors “a simple, easy, income generation” strategies. Sure, until you lose all your gains on a 6+ sigma move.

The proposal here is to utilize a Delta or Directional Butterfly in order to take advantage of a temporary selloff. To summarize I will list advantages followed by disadvantages:

  • Risk is limited to debit paid for the spread
  • Exponential gain on a delta butterfly on a move to neutrality (see chart above) compared to linear gain on spot or vertical spread. You are being paid more and more per unit of stock movement.
  • Max profit is at a determined price so there’s less effort defining an ‘optimal’ exit either through trailing stop or discretionary exits, etc.
  • Position will add additional edge on reduction of volatility associated with up moves and spikes in volatility.
  • 4 options per Bfly so additional commissions
  • Execution platform must support multi-leg options positions
  • Spreads can be extremely wide in illiquid stocks.
  • Maximum gains occur closer to expiration so there is a large time component involved.
  • Profit zone must be large enough to compensate for commissions & spreads so not for intra-day strategies.
  • Capped profit potential compared to nailing the bottom tick on full size……(!)

~ by largecaptrader on June 30, 2009.

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