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Dynamic Iron Butterflies (Part 5)

Better execution can definitely improve profitability of the dynamic iron butterfly (DIBF). This makes me wonder about placing the trade and just leaving it to sit until filled.

Analysis of the maximum adverse excursion (MAE) can help to study this. A losing trade could almost always have been filled at a better price. Out of 3968 backtrades, 736 never get down more money than they are at trade inception. Minute-to-minute volatility in the markets is much greater than day-to-day (seen in my EOD backtest) volatility, which provides hope that most of the 736 would eventually fill. This is no guarantee, however, and 18% includes a big opportunity for otherwise winning trades to go unfilled thereby depressing total return.

Here is the complete MAE distribution across 3,968 backtrades:

dibf-mae-distribution-graph-1-6-17

The x-axis indicates the maximum MAE seen for each particular grouping of trades. The first data point includes all trades with MAE less than 10%, the second data point includes all trades with MAE of 10% up to 20%, etc.

The graph illustrates a majority of trades never get down a whole lot.

Here’s the same information packaged somewhat differently:

dibf-mae-distribution-table-1-6-17

With a profit target of 10%, over 64% of all backtrades never get down more than 20% and over 86% never get down more than 50%.

This suggests a potential benefit to using a stop-loss. I still need to better understand how many winners would be affected, though. How does the MAE distribution compare between winning and losing trades?

dibf-mae-winners-vs-losers-cumulative-distribution-graph-1-6-17

This graph shows the difference to be significant. Over 91% of winners never get down more than 30% compared to just under 13% of losers. The average MAE for winning (losing) trades is 12.9% (57.9%).

Over 98% of winning trades are never down more than 50%.

Is a 50% stop-loss worthwhile?

The cost is conversion of 59 winning trades into certain losers ranging anywhere from 50-90%.

The benefit is an opportunity to save money on 467 trades that would otherwise lose up to ~100%.

This sounds like a reasonable trade-off to me since the number of trades potentially benefitting is eight times the number to suffer a worse fate. And even if the overall return does not improve, cutting down the biggest losers would still reduce the standard deviation of returns, which is a measure of risk.

Confirming this would involve collecting revised loss data on 526 backtrades with MAE over 50%. I should also backtest the surrounding parameter space by checking stop-loss thresholds like 10%, 20%, etc. This could be an awful lot of work…

But who ever said making a business out of trading should ever be easy?

Dynamic Iron Butterflies (Part 4)

My last post was a hodgepodge of information about the dynamic iron butterfly (DIBF) backtest and I’m going to pick up right where I left off.

The differential loss data compounds my concern about the backtest being a combination of two different trades. As a combination, it’s hard to tell to what extent the “dynamic” [put credit spread (PCS)] aspect contributes to the profitability. Worrisome is the fact that 77% of the losses are to the downside: exactly where the “dynamic” aspect can result in greater loss. Let’s take a closer look at the loss distribution:

rut-dynamic-butterfly-directional-loss-distribution-by-12-8-16

Each data point represents what percentage of upside (green) or downside (red) losses occurred at different magnitudes of loss (ROI %). The difference does not look as dramatic as I expected but it still may be. A greater percentage of downside losses occurred at loss levels exceeding 70% ROI. Furthermore, 66% (51%) of downside (upside) losses were worse than 40%. This is a rather large difference especially considering the fact that 77% of all losses were to the downside.

Plotting number of losses, rather than percentage, looks like this:

rut-dynamic-butterfly-directional-loss-distribution-by-number-12-8-16

The difference looks more dramatic here. Total dollars lost would mimic this.

While the PCS is an obvious culprit when studying directional loss distribution, we cannot forget that it benefits the position to the upside. More than just “upside,” the PCS benefits the position as long as the market does not fall more from the DIBF short strike than the width of the call credit spread. This is the “dynamic” portion. I don’t need to do the computations to know this is the vast majority of winners. In fact, this will always be the case:

rut-dynamic-butterfly-risk-graph-12-8-16

If the market falls an amount equal to the width of the call credit spread, this trade will be losing money as evidenced by the intersection of the red horizontal hashmark and blue line being below zero profit (circled in red on the y-axis). That would be my reason for hypothesizing all winners will have fallen less than this amount even though before expiration, unrealized loss is not as extreme (e.g. purple curve).

In any case, what would be interesting to know is how DIBF performance compares to a symmetrical iron butterfly (no PCS). This is definitely a future direction for study.

Next on the docket, though, is analysis of maximum adverse excursion.

Dynamic Iron Butterflies (Part 3)

In the last post I suggested overstatement of transaction fees may have been the difference between a winning and losing dynamic iron butterfly (DIBF) backtest.

I crunched the numbers and can now speak definitively to that hypothesis. Here are the overall backtested trade statistics recomputed for different transaction fees (TF). The second column is the $0.26/option used in the original backtest:

rut-dynamic-butterfly-backtest-stats-adjusted-for-transaction-fees-12-7-16

Indeed, lowering the transaction fees does make this a profitable trade. While the profit factor of 1.15 is not nearly as impressive as the 1.58 seen for naked puts, it is at least profitable.

Put another way, these numbers provide reasonable doubt as to whether the DIBF is actually a losing trade. My preference is still to bias slippage in favor of loss and regardless of the heavy slippage applied, I want to see if I can do anything to boost the average trade and make this strategy more encouraging.

Doing the backtest helped me discover two potential problems.

First, the DIBF has a varied reward-to-risk ratio (RRR). I noticed at times the RRR was downright rotten (less than 1.0). This could be improved by decreasing the width of the put wing. I suspect a lower RRR might lead to a lower winning percentage and a longer time in the trade because the T+0 curve is particularly steep to the downside in relation to the limited potential profit at expiration. RRR was not tracked in the current backtest so my suspicion remains speculative.

My second issue with the strategy is the fact that it is a combination (of an iron butterfly and put credit spread). Selling an OTM long put and buying one further OTM—a credit spread—is what makes it “dynamic.” Before delving too much into the results of a combination strategy, I feel inclined to first study a plain iron butterfly. I may or may not do that before having the confidence to trade the DITM regularly.

Thanks to Pete_UK for helping me calculate the directional breakdown of losses in a hurry:

rut-dynamic-butterfly-loss-breakdown-with-tf-0-26-per-option-12-7-16

This compounds my concern about adding a put credit spread to the iron butterfly.

Dynamic Iron Butterflies (Part 2)

Last time, I presented the overall trade statistics for my first study of dynamic iron butterflies (DIBF). The results were not pretty. Today I want to address the impact of transaction fees (slippage + commission).

I have previously discussed how transaction fees can make or break a study. I subtracted $0.26/contract because I was backtesting some expensive, at-the-money options and when I have to estimate, I prefer to bias in favor of loss. Despite only trading a handful of live butterflies to date, I have never paid more than $0.13/contract in transaction fees (sometimes $0.06). Fast-moving markets could take more than $0.26 but such adverse conditions are rare.

Let’s compute how an overestimation of transaction fees may have affected results. The mean margin requirement (MR) across all trades was $4,878. I subtracted $26 * 8 = $208 from each trade for transaction fees. Cutting that by 50% adds $104 / $4,878 * 100% = 2.1% ROI to each trade. The average trade lost 1.4% so this modification makes the backtested DIBF a winning trade (+0.7%). If even 50% is estimating high then I should reduce transaction fees between $104 – $156. If I use the middle of that range then the average trade gains 1.2%.

Transaction fees alone can make the difference between a 1.4% loss and a 1.2% profit per trade. Financially speaking, those are worlds apart. Thinking about how many traders omit transaction fees entirely for the sake of simplicity just boggles my mind. No wonder so many statistics suggest up to 90% of traders fail within the first five years.

These calculations are based on averages but the exact MR should be considered. Reducing slippage by $52 impacts a $2600 trade twice as much as a $5200 trade. More expensive trades occur in higher IV, which occurs less frequently. I would therefore hypothesize lower MR trades to dominate the distribution, which might boost average ROI further:

rut-dynamic-ibf-study-1-mr-distribution-12-6-16

Indeed, 88.8% of trades had MR within the lower half of the range. While cheaper trades significantly outnumbered expensive ones, only 54.8% of trades had MR below the arithmetic mean. The impact of this skewed distribution is questionable.

Having a more significant impact would be trades where the long option(s) would have been left to expire worthless in live trading. These seemed to occur later in the data series at higher prices for the underlying. Being forced to allow one or two long options to expire worthless saves approximately $20 or $40 per trade, respectively.

I will continue the discussion in my next post.

Dynamic Iron Butterflies (Part 1)

I want to trade butterflies and the only way I can get myself to trade something new is to backtest it. This study is based on a Tasty Trade segment from April 1, 2016.

The subject of this analysis is dynamic iron butterflies (DIBF). Without further ado, let’s jump ahead to the results:

rut-dynamic-butterfly-backtest-stats-12-2-16

This is a completely different profile than that presented in the Tasty Trade video! Make no mistake: with an average loss posted after 3,900 trades, this is ugly.

These negative results were very surprising to me. I have been conditioned to be a believer in short strangles (the butterfly’s undefined-risk counterpart) and I have personally done some backtesting to support that belief.

Before throwing the proverbial baby out with the bathwater, let’s step back and critique the methodology.

My first thought is that I was probably heavy on the transaction fees. $26/contract might be reasonable during fast-moving markets but is probably excessive in most cases.

Second, instead of expiring DOTM longs in the later years of backtesting, I sold them for the nickel (or less) they were stated to be worth. In reality, I probably would not have been able to sell them so close to expiration and I would have been spared that $26/contract. Proceeding in this fashion saved time (it took me four months to do this study) and I am typically comfortable with backtesting bias that favors the losing side.

My third question mark surrounds asymmetrical loss, which may or may not be an issue. I calculated profit/loss in terms of ROI(%) because the margin for a 1-contract trade ranged from $1,401 to $12,400. With ROI(%) itself serving as normalization, I discovered the discrepancy. In some cases the market moved far against the trade to the downside causing > 100% loss (transaction fees). In other cases the market moved far to the upside causing a more limited loss (e.g. 50 – 90%). Some trades also ended up symmetrical: maybe these should be separated out?

The average loss was just over four times the average win, which completely nullifies the benefit of 78% winners. That suggests an MAE analysis to see if stops could be beneficial.

Cost of Doing Business (Part 2)

I believe clients pay millions of dollars every year to have money invested less effectively than they could do themselves. Rather than seeing this as financial-industry brainwashing, however, it may be a simple cost of doing business.

Two necessary components must be in place if the financial industry has indeed perpetrated a brainwashing of the American public. Even if the vast majority of people believe in domain-specific expertise, “brainwashing” implies a widespread propaganda campaign run by the financial industry. I’ve had some casual conversations with investment advisers and I read financial journals regularly. The brainwashing assertion seems too far-fetched for me to accept.

Here is a more positive perspective: investment advisers work as intermediaries. If I am going to pay someone else to replace my brakes then I will pay more to have it done. Similarly, if I am going to hire an adviser or fund operator (by purchasing shares) to invest my money then I will pay more to have it done. The added cost comes in the form of management fees, operating expenses, and lower returns as a result of less-efficient strategies.

Neither financial professionals nor the financial industry are to blame in this new paradigm. The industry is doing what clients ask them to do: invest money. Compared to the alternative—leaving money in savings accounts or under the mattress where inflation-adjusted returns are negative—the industry is doing a good job. Financial professionals may not match the performance of self-directed investors but time is required to learn and to do it for oneself. What you gain from being self-directed is partially offset by the time and effort committed.

In the new paradigm, this is about sweat equity. Those skilled at the trades (e.g. carpentry, plumbing, electrical) are in a good position to invest in real estate because they can fix things cheaper and realize a lower cost basis on property. Those with a penchant or aptitude for math and finance can invest/trade and realize a lower cost basis as well. Those who don’t must leave it to the professionals. In doing so they will pay a premium to have done what they can’t do themselves.

And they will be willing to pay the premium because that is how our capitalistic society works. It doesn’t have to be about manipulative brainwashing; it can simply be about appreciation and gratitude for a service.

Cost of Doing Business (Part 1)

Long-time readers may not be surprised to hear that I am sometimes jaded and skeptical of the financial industry (e.g. optionScam.com). Seen differently, however, perhaps this is just the cost of doing business.

According to some of my teachers/mentors over the years, the financial industry has brainwashed the public at large. People believe investing is an important, responsible enterprise that is best left to the [financial] professionals. I agree with the former and disagree with the latter. I believe many financial/investment advisers are glorified salespeople who push products their firms are contracted to sell. I discussed this in detail here.

Along these lines of thinking, the financial industry has brainwashed society to pay more and expect less. A standard management fee has traditionally been 1% of assets under management per year. In exchange, savvy clients have expected to beat the benchmark.* This means when the benchmark loses money, clients should remain satisfied as long as they do not lose more. Paying someone to lose money that you could lose yourself is anathema to me.

Financial brainwashing also includes the acceptable sale of inefficient services. This involves getting clients to pay up for less-efficient investment strategies than what they could employ on their own (think long stock instead of trading options). Society seems to be comfortable with and accepting of this.

I occasionally seem so down on the financial industry! I feel like a closet conspiracy theorist and I do not like it. My preference is to be positive and encouraging about things.

The time has come to challenge the assertion that society has been brainwashed. A cursory evaluation reveals two components that must be present for this brainwashing to have taken place.

The first component would be a widespread belief that the financial industry has a proprietary edge. Truth be told, I have little understanding what the “public at large” thinks about financial matters and I doubt I’m alone on this. The issue to survey is whether investing success is a result of domain-specific expertise or simply a matter of having the right education. Domain-specific expertise might involve professional research teams able to cover a large number of companies/industries or professional stock pickers powered by innate talent and lengthy experience: forms of expertise no laypeople could develop on their own.

I will continue this discussion in my next post.


* This is changing with the promotion of passive/indexing investment strategies, which always fall a bit short.

Financial Secrets (Part 2)

Today I will conclude with excerpts from Dr. Sarah Newcomb’s article in the Sep 2016 AAII Journal.

     > Financial skills are not easily learned when
     > communication is opaque, and experience can be
     > a ruthless teacher. Leaving loved ones to
     > learn about money management ‘the hard way’
     > may mean they learn too late, or not at all.
     > Remember that even a third-tier topic of
     > conversation is perfectly acceptable to
     > discuss with intimate relations. Neglecting
     > to speak out on financial matters with
     > spouses and loved ones may well be an act of
     > avoidance rather than tact. If we want to
     > leave a legacy of strength and stability, we
     > be brave enough to challenge the culture of
     > silence and speak plainly with our loved
     > ones about money [italics mine].

Dr. Newcomb later mentions data from an American Express study:

Dr. Newcomb goes on to say:

     > Silence may be comfortable today, but our
     > spouses and children will feel the impact
     > of our financial legacy when we are gone.
     > Rather than bequeathing confusion and
     > hardship, opening the door to financial
     > discussions can help prepare them for that
     > more difficult transition. The same holds
     > true when your financial picture is bleak.
     > Sheltering loved ones from difficult
     > realities will not help them cope.
     > Speaking the truth, however painful, is
     > more loving than presenting a pretty
     > falsehood.

I suspect Dr. Newcomb has some powerful lessons for all to learn in her words on this topic.

And on the grand scale, I feel the financial industry promises too much while delivering too little. This takes place at a self-perpetuating cost that people happily pay because the opacity of the subject matter blocks them from knowing any better.

Financial Secrets (Part 1)

To me, the phrase “financial secrets” immediately connotes fraud. I would invite you to read some of my previous posts to find out why. Somewhat ironic is the observation that financial details are held with such secrecy in our society today.

Dr. Sarah Newcomb, author of Loaded: Money, Psychology, and How to Get Ahead Without Leaving Your Values Behind (2016) wrote an interesting article on this subject in the Sep 2016 AAII Journal. I will post some excerpts and [minimal] commentary:

     > We don’t talk about money.
     >
     > According to “Emily Post’s Etiquette,” money is
     > a third-tier topic of conversation, putting it
     > a full class above sex and religion in terms of
     > inappropriateness to discuss in mixed or casual
     > company. Especially among those with wealth, the

More taboo a topic than sex?! This is shocking to me.

     > unspoken laws of society dictate that we maintain
     > a dignified silence on this important, but often
     > divisive, topic…
     >
     > …the purpose of etiquette is to avoid any cause
     > for pain, embarrassment or offense. Yet our
     > reticence on financial matters is so pervasive
     > that it extends to those who would often greatly
     > benefit from open communication. In many cases,

Those of you who have been reading for a while know I’m fairly convinced that options are better than stock. I therefore feel like I walk around with a huge secret about what I do—a secret that suggests most of the financial industry is wrong and does a disservice to its clients by not employing options as an investment vehicle. Because we are so hush-hush about money, this is not something I feel comfortable coming right out to say.

     > well-intentioned civility leads directly to the
     > financial harm, or even ruin, of those we care for
     > most.

Namely my parents. For years they have invested with a money manager who I believe has failed them. The upside to keeping silent and letting them do their own thing is that I avoid the burden of losses that could result from the market turning ugly. The downside is watching them throw away money year after year to generate subpar returns.

I will finish this discussion in the next post.

The Fallout from Financial Fraud

I’ve done a lot of posting in this blog about things in finance that are not what they seem. At worst, we’re talking about a criminal act of fraud. Today I’m going to talk a bit about why we should care.

Taking steps to avoid falling prey to fraud may seem obvious to some. Without thinking too much about it, people may indicate a desire to avoid being taken advantage of, to avoid being robbed, or to avoid a bruised ego (pride).

Because of my background in psychology, I took particular interest in a 2015 research report issued by the FINRA Investor Education Foundation called “Non-Traditional Costs of Financial Fraud.” In case anyone doubts this is a big deal, the Stanford Financial Fraud Research Center estimates $50 billion is lost to financial fraud every year.

Data for the report was collected through an online survey administered in August 2014. Six hundred self-reported fraud victims 25 years of age or older responded to the survey:


These indicate far-reaching adverse events suffered as a result of financial fraud.

The report also asked about more “traditional” costs of a financial crime:

The report suggests psychological and financial distress may be experienced for a long time after the crime has been committed. This probably doesn’t surprise anyone upon reading it. For those who don’t read/hear about it, though, I feel we have much to do with regard to raising awareness of financial fraud.

I’ve learned a saying in my studies of finance and trading: “if something sounds too good to be true then it probably is.” To this end, a little bit of critical analysis can go a long way for prevention.