In Part 3 of our "Premium" series,* we test butterfly spreads to see how this low probability / high profit-potential strategy performs over many occurrences. * Market Measure, Premium: Why Selling it Works, Oct 23, 2014 * Market Measure, Premium: Selling Straddles, Oct 28, 2014 1 of 9
NOTE: For new tastytraders...! A traditional butterfly is a neutral strategy; the belief is that the stock will stay within a range by expiration! Sell 2 at-the-money, and buy 1 in-the-money and 1 out-of-the-money (all calls or puts)! We never sell butterflies, we buy them! The higher the volatility, the cheaper the butterfly 2 of 9
Study 1! SPY: Bought a butterfly every 5 days for the past 5 years! Used expiring month closest to 45 days until expiration! We tested various wing sizes based on a percentage of the underlying price (see next slide for an explanation) 3 of 9
Study 1 In the following butterfly (from dough.com) Each wing is $5 wide (i.e. roughly 2.5% of underlying price on each side of the spread) This first study, we vary the size of the wings. 4 of 9
Results* 5% wide 10% wide 15% wide % of winners 42% 53% 59% Average trade P&L $0.40 $43 $58 Average winner $216 $290 $312 Average loser -$162 -$238 -$289 Max win / loss $491 / -$504 $749 / -$795 $896 / -$1474 Total P&L $96 $10,651 $14,377 * buying every 5 days for past 5 years (260 total occurrences) 5 of 9
Study 2! Next, we examine how implied volatility rank (IVR) affects the profitability of the strategy! We also examine 5 years of daily butterfly spreads using the same stock (SPY) 6 of 9
Results* Below 50 IVR (at expiration) Above 50 IVR (at expiration) 10% wide % of winners 53% 67% Avg. trade P&L $20 $152 Max win / loss $1378 / -$832 $752 / -$733 15% wide % of winners 57% 77% Avg. trade P&L $27 $284 Max win / loss $1982 / -$1498 $896 / -$693 * Buying every day for past 5 years (1100+ total occurrences) 7 of 9
Take aways! Wider spreads have greater probability of profit; they also carry greater amounts of risk. The cost paid for the spread is minimized with greater implied volatility. Average amount paid Wing Span 5% wide 10% wide 15% wide Below 50 IVR Above 50 IVR $235 $221 $724 $523 $1268 $977 8 of 9
Take aways (continued )! Butterfly spreads are a high implied volatility strategy the spread is best taken when the cost of the spread is minimized compared to the probability of profit 9 of 9
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