Thursday, August 27, 2009

When do I cut Deltas on Iron Butterflies?

I have seen this question a couple of times on the blog, and I must say, there is no exact answer, at least not from me. I don't have an exact formula, I go by a guideline and the most important thing for me is evaluating the trade every day before the market closes. One blog reader posted another blog where the author explains his formula, allow me to say a few things about how I have been doing it.

As I mentioned before, I have been following most of Dan Harvey's advice on how to trade these Iron Butterflies. Dan is a veteran trader who mentors at the Dan Sheridan program. I had the great pleasure of meeting him in San Francisco in one of Sheridan's seminars. Dan's rules are complex and quite well detailed, I follow most of them, but I'm the first to admit I'm still studying them, so can't claim to be a perfect follower. One of the most important things to know is that trading rules have to adapt to the trader's style, each trader has his/her own approach to things.

Also, important to notice is that the greeks will be quite different depending on the underlying you trade. The delta : theta ratio also depends on the size of the position, your willingness to take more or less risk, etc.

For the MNX position, I work in keeping the theta to delta ratio of 1:1, meaning if my theta is about 30, my delta shouldn't be much more than that. I also look at the risk profile and evaluate the 1-day 1-standard deviation move, if I notice that a 1-standard deviation move in any direction can take too much of my profits, I'll come in and cut some of the deltas. Every day I post those charts and the light-blue area is where Think or swim estimates 1 st. deviation to be for 1 day. Another rule-of-thumb I use is to place contingent orders in points where my delta is twice as much as my theta, to cut it in 1/2 and bring it back to a 1:1 ratio.. This has worked fairly well. I preffer to keep these contingent orders at least 1 standard deviation away from the closing price, otherwise it may whipsaw, as it happened to me back in June for my DIA Iron Butterfly trade.

For the RUT position, I don't know yet.. Sorry, no genius here, just a guy working on his craft :) I believe Dan Harvey recommends a theta to delta ratio of 3:1. However, this is for larger positions, My RUT position is the same size of the MNX, and because this is the first time I trade it, I'm not quite sure where the ratio should be. Honestly, I've been looking at the 1-day 1-st. deviation zone in the profile chart and evaluating if I can handle that kind of move, if not, I cut the deltas, if yes, I simply place the contingent orders there.

I try cutting the deltas in about 1/2 when I use contingent orders. It is BEST when you do this overnight and stop looking at it. This very month, I was watching when the MNX dropped 2 st. deviations and I over-adjusted the trade. The best practice, as far as I can tell from back-testing is to cut it in 1/2 and cut in 1/2 again if it keeps on moving.

Then again, evaluating the position at the end of the day is the most critical element here. I ask myself the question: If we go Up, am I ok? If we go Down, am I ok? If not, I adjust before closing, if yes, I put contingent orders around the 1 st. deviation zone.

I hope this helps, feel free to post your comments, share ideas, suggestions.. It is an open board here.

Cheers to our Success!

First the other trader's opinion is here:


Andrej said...

Hi Gustavo,
I’m very happy I found your blog couple days ago. Tracking back your trades was helpful and big motivation to start trade butterflies. Do you have any update about your butterfly rules? Andrej(Prague)

Gustavo's Trades said...

Hey Andrej, thanks for the posting, sorry it took me so long to get back to you. I have not changed much on the butterfly guidelines, I kept them pretty consistent for the time I was trading iron butterflies.

With the current market volatility you may find yourself adjusting more often and if the market does a lot of zig-zags you may find yourself hedging and re-hedging from day to day. So watch your deltas and stay on top of your trading plan (max loss, adjustment, etc) and the daily position reviews.