Playing Over-hot Underlyings with the Call Butterfly

A call butterfly is a fully hedged options trade …

… with an upwards bias.

It consists of four call options.

…and 2 sells.

One can play any overtly rising underlying with the call butterfly, without batting an eyelid.

Why?

Firstly, and most importantly, one is fully hedged.

Meaning?

At first look, the call butterfly seems market neutral as far as basic mathematics is concerned, that is +1, -2, +1, net net 0.

So, net net, one isn’t looking at a large loss if one is wrong.

When is one wrong here?

If the underlying doesn’t move, or if it falls, in the stipulated period, then one is wrong,…

…and one will incur a loss.

However, the loss will be relatively small, because of the call butterfly’s structural market neutrality.

And that’s magic, at least to my ears.

Method to enter anything flying off the handle with the chance of a small loss?

Will take it.

Then, also very importantly, the margin requirement is relatively less, when one uses the following chronology.

Then come the sells.

Upon the upholding of this chronology, the market regulator is lenient with one on margin requirement, as long as the trade-construct is market neutral.

Typically, for one butterfly, total margin requirement is in the range of 50 to a 100k.

Now let’s talk about what one is looking to make.

5k per single-lot trade-construct, if it’s fast, as in execute today, square-off tomorrow, or even intraday, if expiry is close.

10k if slow, as in 7 to 10 days.

If the butterfly is not yielding because the underlying is not moving, then one is looking to exit, typically with a minus of under 3k.

Just do the math. Numbers are great.

What kind of a maximum loss are we looking at, if things go badly wrong, as in if the underlying sinks?

5k to 10k.

Can the loss be more?

If the trade construct is such that the butterfly can even give 40 odd k till expiry, one could even be looking at a max loss of about 15k too.

Here’s an example of a call butterfly trade that can lose around 15-16k, but has the potential to make upto around 45k till expiry. The graphical representation is courtesy Sensibull.

I mean, it’s all still acceptable.

Tweaks?

Let’s say one is losing.

Sells will be in biggish plus.

Square-off the sells. Yeah, break the hedge.

They are losing big.

With some time to go till expiry, if the underlying goes back up, the buys gain.

What one makes off the trade is proportional to how much the underlying goes up.

It’s riskier. Correspondingly, profit potential is higher.

Money risked here will be up to double of the fully hedged version of the trade, and one could lose this amount if the underlying does not come back up appropriately and in time. Pocketed premium of the squared-off sells softens the hit.

Therefore, it makes more sense to pull this tweak with at least ten days to go before expiry, giving the underlying time to recoup.

Got another tweak.

Underlying’s on a roll, and you want to make the most possible off the opportunity.

Square-off the sells at a huge loss.

Let the buys, which are winning big, run for some part of the day.

Chances of them yielding more are very high.

If the underlying promises to close on a high, square-off the out-of-the-money buy before close of trade, and take the in-the-money buy overnight.

Risky, though.

You could lessen your risk, and increase your chances of taking most profits off the table by squaring off the in-the-money buy and taking the out-of-the-money buy overnight.

Square-off the overnight buy next morning on a high, or wherever feasible.

With this particular tweak, the trade becomes somewhat more like a lesser exposed futures transaction, at least for some time, after the hedge is broken.

There’s another thing one can do with the call butterfly.

One can adjust it as per the level of perceived bullishness.

If -1 and -1 are set at the same level, one trades for averagely perceived bullishness.

If one -1 is closer to the lower +1, and the other -1 is above this first -1, then one trades for below average perceived bullishness.

If one -1 is closer to the upper +1, and the other -1 is below this first -1, then one trades for above average perceived bullishness.

Anything else worth mentioning?

Volume. Need it.

Scaling up needs to correspond to one’s risk-profile, requirement, temperament and acumen.

One can make it an income thing by scaling up, during bull runs, or generally, just in case an up move is tending to pan out.

One can make the call butterfly do a lot of things.

It’s a very versatile trade to play a rising market, with low risk and low capital requirement.

🙂

The At-Par Point

One grapples with this one, …

…always.

There’s something about the at-par point.

No matter how much logic we try, when the at-par point arrives, logic fails.

Carrying a loser?

Determined to carry it through till 3x?

Wait till the at-par point arrives.

See how psychology changes.

Watch yourself liquidating the stock, despite all previous planning.

Happens all the time.

Carrying a winner?

Underlying then falls to at-par?

Watch yourself liquidating at the speed of light.

It’s ok.

We’re humans, and aversion to loss is a human trait.

This aversion to loss makes us follow the dictates of the at-par point.

How do we go around this, as traders or investors?

Meaning, as we advance in our professions, we don’t wish to be dictated terms to by a particular “non-technical” and “artificially” psychological price point.

So, let’s try and find a workaround.

Underlying is winning. Raise your stop in a defined fashion.

When underlying starts falling, it will hit your stop.

At-par won’t be touched, so it doesn’t even come into the equation.

Underlying is down. Hmmm. What do we do here?

We really want to meet the at-par point here.

We’re desperate.

Average down.

The at-par point lowers.

When market conditions change, it arrives early.

Don’t wish to average down?

Not convinced about the stock anymore?

Wait.

At-par might or might not arrive.

Arrives?

Well and good.

Doesn’t arrive?

Look to exit as best as possible, if you’re tired of holding.

As investors, one can think about only getting into stocks where one is confident of averaging down if the stock falls. (Traders are suppose to cut trades at or around their stop).

Tweaking (lowering) the level of at-par helps faster recovery in the markets greatly.

Insiding

The correct market strategy for oneself…

…is like a holy grail.

Some don’t attain it at all.

Mostly, one does get to it but is not able to maintain it.

It’s great if you can arrive at your correct strategy, and keep it alive, forever.

However, that’s a huge statement.

Lots of caveats will need to be addressed before this statement can be made achievable.

What works for me is lots of hit and trial.

Levels internalize.

One gets a feel for what is disturbing (to oneself).

Internalization gets our reflexes going on auto.

“Insiding” is a term that I’ve made up signifying the struggle one goes through recognizing whatever needs to be recognized and arriving at one’s correct strategy.

This act of recognition comes from taking hits, year after year, till one is street-ready to handle whatever the street can offer at its worst.

Market action is mostly about making mistakes.

One keeps these small.

Whatever you end up doing right for yourself, …

…, yeah, that’s what you’re scaling up.

Out of ten attempted ideas, one might work.

Out of a hundred, three might work exponentially.

These are the ones.

Stick to these.

Scale them up.

Whatever it has cost you to arrive at them, is mere tuition fees.

Yes, that’s how you’ll need to see things, to remain sane.

Be happy – at least you have something concrete in your hands – a strategy that works – that’s huge.

The moment you see it turning incorrect, leading to market mistakes, just tweak, tweak tweak till the strategy starts working again.

Tweaking will go on as long as markets exist.

What’s a market mistake?

A market mistake is anything that makes you lose money consistently.

A correct strategy is something that yields money consistently.

That’s why one needs to keep things small till major mistakes are out of the way.

Make mistakes, sure, they are bread and butter.

Just don’t repeat them.

Using Auto-Manual Mix Towards Peace of Mind

Create…

… an asset.

Move on.

Create…

… next asset.

Move on.

Loop to the nth and decide what your magic n is.

Retire.

Ha!

Formula for financial independence in 22 words?

You decide.

How?

The act of creation is manual.

One can use many tools while putting the asset together manually. That’s absolutely fine.

Let the asset loose.

From this point on, it’s on auto.

It’ll remain on auto, hopefully, till its logical conclusion is reached.

If the asset misbehaves in between, it will attract your attention.

If your attention is attracted beyond your critical mass, you will stop what you’re doing and attend to the asset.

You will either tweak and repair and let it loose once more.

If the asset is beyond repair, you will terminate it, i.e. sell it off, even at a loss. After all, it is misbehaving. You don’t wish to hold something that bothers you.

Peace of mind is the most valuable asset in your portfolio.

Going Beyond Price Action

Is price action the holy grail?

You’ve rid yourself of all indicators in search of something that holds.

In forex, you’re probably not looking at volume either.

What you’re left looking at is the behaviour of price.

Price patterns, expressed in the form of candles, contain a psychology.

You are trying to understand this psychology in order to put on a winning trade.

However, everyone else is also watching the same patterns too, including the big boys.

Who are the big boys?

Institutions, banks et al.

Why are we talking about them?

They are the one’s capable of creating enough buying or selling pressure to determine the direction of price. Retail people, like you and I, are not.

That’s why.

And these same big boys know the patterns that you are looking out for, and are going to react to.

What do they do?

They tweak the patterns.

It’s the obvious thing to do. Stopping the public out will give them a smooth run later.

Is tweaking the patterns a biggie for them?

No.

Determining the direction of price is like winning a war.

What’s it going to take to win a small battle, like tweaking a pattern?

A fraction of one’s resources.

Where does that leave you?

If you’re looking at pure price action, you probably might not fare too well.

You have no choice but to look beyond.

What is beyond?

Truth is truth.

If the market wants to go somewhere, because of actual demand and supply dynamics, well, then it wants to go there.

It will reveal that with price action.

You won’t miss the message.

How can one overlook a very large-tailed candle, or an obvious support or resistance, for example?

As you are getting ready to act, based upon the obvious pattern you are seeing, you also observe, that most of the time, price is not behaving like the pattern is saying.

If the pattern is just too obvious, you need to go one step further and put on the trade, taking tweaked conditions into account.

Look at the chart for obvious points that the big boys might be targeting. Go beyond these points and set the levels for your entry, stop, and if it’s part of your strategy, your limit.

What have you basically done?

You have believed in the obvious price action that you have seen.

You have tried to factor in tweaking.

You have implemented your trade in a manner such that the negative effect of tweaking will just about give you entry, but the big boys will probably not be too bothered about going right up to the level of your stop, because its positioning is such.

This will fail.

Sometimes.

This will succeed…

…at other times.

Whether you make money or not will depend upon how you manage your winners.