lystn

Hey everyone, Kirk here again and welcome back to the daily call. Today, we are going to be talking about why I’ve traded a lot more iron butterflies during low IV markets. This is always one for people who are new to Option Alpha. It’s a little bit of a confusing concept because we see low implied volatility which we’re generally and most of the time, although we had some high volatility spikes here in March and in February which were good and good trading opportunities, but most of the time, we’re in low volatility. Why have I started trading a lot more iron butterflies? I think there's a couple of reasons why and I want to go through this in the podcast just to help share what we've been doing. The first thing is when we go back and we look at research on what works just generally using our profit matrix research which you guys can all get to at optionalpha.com/profit. But when we go back and look at back-tested option strategies, we’d know that in low implied volatility environments, option selling still works. It’s just as simple as that. Option selling still generates nice expected returns, profitable trading strategies, but the key is finding premium. I think it’s really what it comes down to. One of the better strategies that we found in low volatility was a variation of either a straddle or a wide strangle. Wide strangles, although I love to trade them in low volatility, like really wide iron condors, basically, you just don't get enough premium to do them in low volatility, especially on some of the lower ETF values. If there's an ETF under $50, selling an iron condor during low implied volatility might generate say $30. It's not a lot of money per contract, per spread and it’s a lot of commission to do that. Now, we have to start thinking to ourselves, “Okay. Well, if we know that we still need to be selling options, how do we replicate to some degree, a strangle type payoff diagram where you have wide breakeven points without doing an iron condor that doesn't make any money or basically doesn't collect enough premium to do it?” The way that we that is by doing a very wide straddle and using a synthetic iron butterfly. The inside of an iron butterfly is basically a straddle. You’re selling at the money options. During low implied volatility, at the money option contracts still have significant amounts of value. In some cases, a couple of dollars worth of value. Now, we start selling these at the money straddles and then because implied volatility is so low, what we have the ability to do is buy wings on these straddles very far out or in some cases, actually not that far out for very cheap amounts or very cheap premiums. One example of this just to use a very standard example which helps out is let’s say that the stock is trading at $100. We might sell the 100 strike put, 100 strike call, basically the at the money straddle and collect say $6 of premiums. Now, our breakeven points are $6 out on either end. Now, even though we were selling at the money strikes, because of the premium that we collected which was $6, now our real breakeven points are 94 on the bottom side and 106 on the top side. Now, it actually replicates to some degree, a strangle or an iron condor type breakeven points, like those further out breakeven points. And even though we sold the at the money straddle at 100, we now maybe able to buy say the 95 puts and the 110 calls or something around there, something further out on either end for very, very cheap premium. Say we bought these options for say $.8 or $.10, so basically $20 we give up of our entire premium. That's really the case. In low volatility, it does not cost a lot of money to buy these further out legs. Even though we collected a $6 credit, so $600 of notional value, it might cost us $20 to buy these further out legs for protection and basically to reduce margin, but if we’re still taking in say $580, it's worth it to pay the $20 or $30 or $40 in some cases to buy all of the legs on the outside to give ourselves defined risk, so that if volatility does spike, we’re not caught basically holding a bag of positions that have undefined risk with a lot of huge spike in volatility, etcetera. That’s why we’re starting to do a lot of iron butterflies. It mimics a lot of the strangle, iron condor type breakeven points while giving us the ability to collect enough premium to make the trading worth it and we’re using those out of the money options as protection against black swan type of events, market spikes of volatility and it's really, really cheap. Because implied volatility is so low, those out of the money options are very, very cheap. You don't have to go that far out of the money to buy those and they end up becoming very, very cheap insurance. This worked out very, very well during the recent move down that the market had back in February because we were under-allocated, we kept our allocation size small, kept our overall allocations down and we had a lot of iron butterflies on, so we could afford to wait for the market to bounce before we took a lot of these things off because we had that protection in place and it was very, very cheap. In some cases, we paid $4 or $5 for some of these protections and these out of the money options on the long side. And yes, they were far out when we entered them, but then, when the market started to mini-crash, those really gave us a lot of protection for margin and allowed us to then scale into some of the higher probability, higher payoff trades during high implied volatility. I think they work really well during this environment. We’re going to be setting up as we release our auto-trading software. We’re going to be setting up some of these iron butterfly auto-trading bots that you guys will be able to use and clone over and that’ll help honestly me in just setting up this low volatility strategy on a consistent basis. As always, hopefully this helps out. Until next time, happy trading!