Butterfly Skepticism (Part 1)

Before I continue the research plan, I want to express some skepticism I have toward butterfly trades based on what I have seen in recent years.

Butterflies have been a “secret sauce” of the options trading community for some time. They come in all different shapes and sizes with diverse trading plans incorporating varying degrees of discretion. I have seen many traders and vendors describe more/less elaborate adjustment plans that look, at cursory glance, very impressive in their presentation.

Most of these adjustment plans are simply position overlays added later in the trade. Adding [a] management criteria [criterion], giving the trade a fancy name, and selling it as a new idea for $$$ seems alarmingly deceptive to me especially in the absence of valid backtesting to support it.

Most of the complexity amounts to adding subsequent positions within specified time constraints. For example, adding a put credit spread (PCS) later in the trade to raise the upper expiration line may seem appealing. Consider these:

• Add PCS when the 1 SD range no longer breeches the center of the tent
• Add PCS when net position theta turns negative

If they happen at all then either is going to be triggered much later than butterfly initiation since decay occurs over time. I strongly believe nothing to be magical about any particular DTE for trade inception or adjustment. Failure to explore any other time a trade could be placed or adjustment made is short-sighted as I have written about here, here, and here.

If I would consider doing the adjustment later, then I should backtest the adjustment earlier as well. With regard to the above example, I already plan to study shorter- and longer-dated PCS as part of the automated backtester research plan. Whether the trading plan works as a whole is simply a question of whether the sum of its parts (e.g. symmetrical butterfly plus shorter-dated PCS) is profitable.

I will continue next time.