Butterfly Hedging

• stevenplace
• May 5th, 2009

We’re starting to see some more weakness come into the small cap, momentum driven names. And while we’ve been in a great trend, we can’t deny the distinct possibility of a pullback in the near term. So while we don’t know the outcome of price, we can at least hedge for it. One of the ways I hedge when I have a delta positive portfolio is buying butterflies.

If you didn’t know, a butterfly is essentially an iron condor smushed together, or you could consider it two verticals sharing the same selling strike. They have a lower probability of success than other spreads, but the risk is limited and the reward is several multiples of your risk. We’ll go over two potential plays.

The first one is in the VIX. Adam Warner pointed out on stocktwits that a whale came in and put on this trade:

BUY +10,000 BUTTERFLY VIX 100 JUL4 09 40/50/60 CALL @1.00 LMT

Here’s the risk profile:

There’s probably some other trades going on around this one, but let’s consider it in isolation. You’re risking 1 and your max reward is 9 at the 50 strike. So max 9:1 reward to risk, but let’s cut it in half and say you’re average r/r is about 4R in the trade. Not bad for a limited risk play. Notice that the chance of success is about .25, so you pay for the high reward and limited risk with a low probability.

This trade works well as a hedge if you’ve got a lot of negative vega and positive delta on your books. Say you’ve got a bunch of puts sold in a variety of names, so you’ll lose money both on an uptick on vol as well as a drop in the market. This trade hedges for that.

Do note that there’s other voodoo going on in VIX options so if you don’t know what you’re doing, I wouldn’t suggest this trade.

Instead, let’s look at something a little less exotic:

BUY +10 BUTTERFLY RUT 100 MAY 09 490/470/450 PUT @2.85 LMT

So you’re risking 2850 and you’re max gain is about 17000, so it’s about a 6R trade at max, but we’ll cut it in half to average it out– a 3R trade. You’ve got a 1/3 chance of making money… are you starting to notice the inverse relationship with p(success) and risk/reward?

Anyways, this play works out well if we drop below 487 by opex, which is very feasible. Do note that the RUT index is cash settled (correct me if I’m wrong) and they have expiration a day earlier. But paying a little for insurance, especially after a run like this, is a good idea.

Tickers: rut

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