Wednesday, April 15, 2009

Straddles vs. Iron Butterflies

After receiving several questions and comments regarding yesterday’s VIX Expiration Straddles and a related prior post, A VIX Butterfly Play, I realize that I skirted a fundamental options issue that I should probably have placed more emphasis on: unlimited vs. limited risk.

The issue centers around a key concept in trading options: is the maximum loss on a position limited? In other words, at the time the position is opened, is it possible to define, in dollar terms, the maximum loss and the price points at which this loss will occur?

The question can also be addressed in graphical form.

In the profit and loss graph below, courtesy of optionsXpress, I have replicated a trade that is similar to the straddle trade highlighted in VIX Expiration Straddles, except that it uses May options.

If the trade has unlimited risk, such as is the case with the short straddle below, the profit and loss graph will show diagonal lines at the extreme left and right side of the x-axis.

By contrast, it is possible to augment a short straddle position by buying insurance to protect against unlimited losses in the form of an equal amount of long calls (known in some circles as “buying the wings.”) The result is an iron butterfly, with the “wings” limiting losses.

The graphic below shows the same trade as the short straddle above, but with the additional purchase of out of the money puts and calls. Notice how the new wings are the horizontal lines that reflect limited losses of $440 in this position.

The wings are particularly important in the event of extreme moves. In the short straddle, every dollar move in the VIX above 45 results in an additional $1000 loss. The iron butterfly, however, limits losses at 40, so the VIX can spike as much as it wishes over 40 without impacting the bottom line. The same dynamics are at work were the VIX to plunge dramatically.

Note also the cost of the insurance will reduce the maximum potential profit (which falls from $5510 to $2060) by 63% and also shrink the price range in which the trade is profitable (from 31.99 – 43.01 to 35.44 – 39.56) by the same 63%.

It may be helpful to think of the cost of buying the wings as the price of insurance to limit risk. Most traders prefer to pay the insurance premium and sleep better at night, but there are those who prefer to forego the wings and hope to avoid a disaster. This type of approach can be effective in the short-term, but over the long haul is an excellent way to lose all your trading capital.

For the record, the same relationship described above with respect to straddles and butterflies is analogous to the relationship between strangles and condors.

[graphics: optionsXpress]


Mikkel said...

Do you have any opinion or numbers about which way the VIX moves when the market opens on settlement day? Also, why does the VIX settle with market open, that's kind of confusing as I've noticed that option prices are all over the place at open and can take 20-30 minutes to calm down.

Anonymous said...

I did some looking and even though the CSFB Index, according to Barron's, indicates high fear with high levels and low fear with low levels, it actually looks like it's the OTHER way around, so that a high VIX would correlate to a LOW CSFB Index. Can you corroborate this?


Unknown said...

From where are you getting these options charts? They are wonderful. I thought it was optionsXpress, so I signed up, but they have nothing like that.

Bill Luby said...

Hi Jeff,

The charts come from optionsXpress. and in the time since I first posted this, optionsXpress has improved them a little, with separate P&L and probability charts.

I will describe how to create your own identical charts in optionsXpress in a future post, but for now when you are viewing options chains sorted by "Type" and see the "Trade/Watch/Calc" links at the end of each line item, click on "Calc" and then click on the "Calculate" button when the new window pops up. That should give you what you are looking for.



Bill Luby said...

Mikkel and Anon,

It appears as if I somehow overlooked your questions.

If it is not too late to do so, here is a quick response.

Mikkel, regarding the settlement process for the VIX, it generally follows the settlement process for the SPX -- only 30 days earlier, so it inherits some of the idiosyncrasies of the SPX settlement process, including a special opening quotation (SOQ) used for settlement. In general, I think the VIX SOQ is usually appropriate for the open. There have been some exceptions, notably in SPX Options Carpet Bomb Pushes VIX SOQ to 63.04 (!)

Anon, I have a request in to the creators of the CSFB for a full set of historical data and will have some more detailed commentary on that indicator when I get the full data set. Clearly there are times when the VIX and the CSFB are positively correlated, but to your point, it looks as if there are other times when they are negatively correlated.



Anonymous said...

Hi, Whats the difference between a butterfly and an iron butterfly?



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