Most of the IFA strategy was flushed out in this post. Recently though some trades like KRE, SMH, and IYR have tested their top long call as the market has continued to rally, which can be expected. When we buy that call typically IVR is high, and the strikes widen, and now that one side has been tested, I want to look at trade management as potentially one side of the trade is collected virtually all of its value. When one side of the trade has lost 85% of its value, I want to close out the untested side, and then remain short a vertical spread if enough time is left in the trade.
On 1/8/19 in $KRE I sold to open the 2019-02-22 expiration 44/49/54 iron fly. IVR was 61.
The complete breakdown is as follows:
Bought $54 call @ $0.26 db
Sold $49 call @ $1.88 cr
Sold $49 put @ $1.82 cr
Bought $44 put @ $0.48 db
The entire trade was done for $2.96 cr. I paid $0.26 + $0.48 = $0.74 db for insurance on a $3.70 cr straddle. The insurance cost was around 20% of total premium collected. Keep in mind this is almost the original amount of the profit target of a naked straddle position or 25% profit target. Meaning our insurance (debit) reduces our credit. However the profit targets as a percent gain is still the same at 25% for iron fly and straddle.
The iron fly increases potential time in trade (risk) sometimes pushing the trade out another 10 days on average (from 21 days to 30 days). In certain cases where the 16 delta iron fly is traded a 75% profit target can be achieved from some tastytrade studies, but as you can imagine gamma risk is probably too high trying to attempt 75% premium collection between two 16 delta wings.
On 2019-01-25 the underlying closed at $53.50 or near my 10 to 16 delta call, or stop outline in the IFA trade strategy. There is 28 DTE remaining for this trade, our time stop is around 2019-02-10, roughly 12 days before expiration.
The lower part of the spread was trading at on 2019-01-25:
$49 put @ $0.23 (Now 11 delta)
$44 put @ $0.03 (Now 3 delta)
Our “stop put” at the $44 strike has basically gone to $0 or has $3 left in value per 1 lot. I consider this always insurance and expect it to go to zero, but in this case it works out because our top 10 to 16 delta call (other side of the iron fly) has been hit.
If we are building mostly a synthetic straddle, if I look at the $49 put it has lost:
(1.82 - 0.23) / 1.82 = 1.59 / 1.82 = 87% or roughly 90% of its value with 28 DTE.
There is almost no reason to hold this short put in my opinion as most of the value has deteriorated as the underlying has moved away to to the tested 10-16 delta insurance OTM call/put.
This is one major problem with buying the lower strike put because we also lost $0.48, to have peace of mind, and reducing the BPR, while also gaining almost the full value of the $1.82 short put. Imagine if the trade landed near the short strikes on the expiration (or 23 cents away) our OTM put would still expire worthless.
Simply put, this side of the straddle has accomplished 85%+ of its full value, and the trade should be taken off to lock in the profit and reduce risk.
Now I am short the $49 / $54 ITM vertical spread, and am “hoping” this trade will mean revert in the next 16 days (from exit), and most the time in the backtest it does. Keep in mind this trade has not even reached 50% of max loss in terms of BPR.
In managing this loser, I capture almost the entire gain of the untested side, but our total profit target for the iron fly was $2.31.
The other side of the vertical spread sits at:
$54 call @ $1.00 (0.94 x 1.07)
$49 call @ $4.82 (4.35 x 5.30)
For a total of ~$3.99 debit to close.
The OTM call (insurance) has increased by almost a factor of 400%. So now I can see the benefit of the insurance.
The untested side was closed for a $0.20 debit (from a total credit of 1.34) or 85% gain. My 25% target of the iron fly was $2.21. Minus $0.20 from $2.22 and you get $2.01.
To hit the profit target of $2.21, the vertical spread needs to trade at $2.01, or a $1.98 drop in premium (roughly 50% drop).
Putting It Together
Lately the market has continued rallying and IVR has dropped. But it has rallied too far, which is normal, 68% or 80% of the time it does not. I lose some of the delta neutrality when I close out the trade, since I now have only the vertical side of the trade on which is directional. This is fine because one side has lost 85% of its value.
Since the trade strategy category is mean reversion, we can expect that the underlying behaves within its statistics and in the next few weeks we will behave within the statistical edge and revert back towards $49. My profit target is now break-even is now $49 + 2.01 = $50.01 by expr, now with no downside risk, since we have removed that part of the spread. My break-even was $2.98 in either direction before, now I subtract 20 cents from the break-even, or $49 + $2.98 + $0.20 = $51.78. When this trade was done the underlying was @ $53.47. I’m protected at $54, and the previous day low was $52.21.
To remain disciplined I put a GTC limit order in at $2.01 ($2.21 target - $0.20 untested side closing debit) which matches my original profit target of $2.22. This way if the underlying moves back to $49 I push risk more in my favor because my $49 ATM put will not offset the value.
Actively managing these losing trades will increase win percentage materially over the long run as the market could push back. The cost of taking this risk is $0.20 of the total profit target of $0.74, or 27% of the total profit potential.
In other tastytrade research (sourced below) typically managing trades like this increases the win rate by 10% or more, especially in high IV, even for inverting straddles. P&L per trade is also increased.
I plan on implementing this new trade management process and reducing any legs if they fall by a value of 85 - 90% and there is greater than 20 DTE left, basically allowing 2 weeks of time to pass to allow the trade to mean revert.
One aspect to delta neutral trades to increase your edge further is by managing risk. For strangles tastytrade rolls the untested side into a 30 delta OTM call/put or straddle to collect more premium. In IFA I want to manage the trade by closing out the untested vertical if it has lost 85-90% its value. This means of course the trade is already a loser (which happens 73-90% at in time in the trade) since it has not hit the profit target before one side has lost all of this value, but that is ok.
I can see why adding more legs, even in liquid, 4 star underlyings, can be challenging. The BAS on the put sold at $0.03 was quite wide; $0.02 x $0.12 which is material BAS. When closing out the untested side the OTM put was outside of the 2 SD move or 3 delta. Needless to say 3% chance to be ITM, is a hard sell!
In expanding the strategy further I will record the 2 SD move, on both sides, from when the trade was put on (or the 5 delta strike). If the underlying hits this 2 SD mark I will consider also selling the insurance! By the time an underlying gets to 5% probability the insurance has probably done its purpose, especially in the case of ETFs where it is probably safe to sell and ride the ITM tested straddle option. There always exist the chance of an 3, 20, 100 SD move, so when removing the insurance this risk always exists and is up to the discretion of the trader and their risk tolerances. Also the strategy as a whole should be evaluated if a 2 SD insurance sale should be done, if 1 trade in 20 is doing this, then it is probably warranted to do this since the total strategy risk is probably quite low. However if 7 of 20 trades are doing this because of cross asset correlation risk (CAC) insurances should NOT be removed as the strategy is exhibiting a drawdown risk.
Using this trade management of by selling the untested side at 10-15% of its value increases risk of the original trade, and increases long or short delta exposure depending on which vertical is closed, but will ultimately make the strategy more profitable over many trades if initial trade size is manageable.
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