Butterfly Spreads for Harvesting Risk Premia

We have discussed trading strategies for harvesting volatility risk premium. In a similar context, Reference [1] examined the use of butterfly option positions as a trading strategy for long-term investors.

An option butterfly position is a limited risk, non-directional options trading strategy that is designed to take advantage of a stock’s lack of volatility. The strategy generally involves buying and selling options with different strike prices, but the same expiration date. For example, the long call butterfly spread is created by buying one call option with a strike price that is below the current price of the underlying asset, selling two call options with a strike price that is near the current price of the underlying asset and buying one call option with a strike price that is above the current price of the underlying asset.

The article pointed out,

The Broken Wing Butterfly (BWB) has become a popular options strategy for traders. Profit is generated primarily by exploiting option value time decay. In this paper the selection of the option strikes to be used along with trade entry and exit parameters, such as time to expiration and profit and loss targets, are optimized using over a decade of historical option data of the S & P 500 exchange traded fund (symbol: SPY). The importance of selecting an optimal strike mapping method, by which strikes are assigned in any time period, is highlighted. Of the three methods considered, the normalized strike mapping method was found to be optimal. Optimization was performed using a differential evolution (DE) evolutionary algorithm. The objective function used for optimization considered final cumulative profit, volatility, and maximum equity drawdown while achieving a high trade win rate. A trade example is given to illustrate the use of the obtained results.

This article provided some formal tests for the popular Broken Wing Butterfly strategy. However, we note that,

  • It did not address the underlying PnL/risk drivers of the strategy, i.e. volatility and skew risk premia,
  • It attempted to study the profitability of the Broken Wing Butterfly strategy by performing numerical optimization. However, no out-of-sample and robustness tests were performed.

Let us know what you think.

References

[1] Munoz Constantine, D., Tymerski, R., & Greenwood, G. (2020). Differential Evolution Optimization of the Broken Wing Butterfly Option Strategy. Technology and Investment, 11, 23-45. https://doi.org/10.4236/ti.2020.113003

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