What's a good return/risk ratio for long butterflies?

T

trendisyourfriend

Hi guys,

I'm thinking of buying a long butterfly spread for JNJ expiring on July 16. Earnings report July 21. The last ex dividend date was May 24 and there hasn't been one announced for the near future yet..

IB says the max return is 272 and the max risk is 728. This gives a return/risk ratio of 0.37.

Is this an acceptable ratio? For a long butterfly, should the return always be greater than the risk?

Thanks
 
First, IB's return/risk is usually a little off/wrong because they assume you getting the worst price possible since they can't know what actual price you may end up paying.
Calculate your own R/R simply by dividing the max return by the price you're willing to pay for the butterfly, which usually should be near the mid price.

Secondly, the prices & odds are decided by the market where buyers and sellers affect the prices until they're "acceptable" to everyone. In this case sellers may believe that the price won't move much. But if you go to October, for example, then the R/R may look more "acceptable" since you may pay only $3.50 for a butterfly that can be worth max $10. So you'd have to take more risk and wait longer to have "better" odds, though in the end they may not be better since the stock price is more likely to move more by then. There is no edge in generic option bets because option prices reflect the odds.

Lastly, the R/R on a butterfly can't be too accurate because to get the max return you'd have to wait till expiration and have the price land directly at the middle strike, which is very rare.
The R/R of a basic vertical spread should be more accurate because the price can often end up below or above both strikes.

Butterflies aren't bad trades and are best for betting on volatility drop/crush, while not expecting the stock to move too much. Your JNJ example does look expensive, which may indicate that the market already expects the same outcome as you do, so there isn't much profit to be made. While you could lose majority of the bet if there is an unexpected outcome, so it may not be "acceptable" if that's a big bet for you.
 
Simple answer is you can't compare risk reward ratios of differing flys,I.e. ATM vs OTM...

The not so simple answer is YOU can look at Delta /Theta ratios,Theta/ Gamma ratios or whatever floats you boat..

The not simple answer is skew Delta, perceived edge from skew,expected return based on price distributions per your chosen vol.

More to the point,why are you looking at a fly??? Direction,IV,skew????

Are you looking at any scanners/ analysis tools??

At your level,I would be looking at Option samurai(free trial), and/or OptionStrat(limited free use)


MarketChameleon is decent but pricey,Orats is great but too advanced for you...
 
Last edited:
taowave said:
The not simple answer is skew Delta, perceived edge from skew,expected return based on price distributions per your chosen vol.
More...
What is skew Delta? Can't seem to find the definition online.
 
Good work!!

If you are trading a vert/fly,you may notice that there are different vols at different strikes..

The question is,as the underlying moves, how do the option vols react..Do they behave under a sticky Delta or Stick Strike framework..

Im not looking at a screen,but if you look at short dated MSFT upside calls,you will see that the 110 percent of spot calls trade at a much higher vol thsn the ATM.

The question is,if MSFT rallies 10 percent, what vol will the option that was 10 percent OTM (110 percent of spot) trade at as it now is the ATM option.If it's truly Sticky Delta,there should be a vol crush in that line.

Depending on how you set up your fly/ structure,1x2x1 vs 1x3x2 vs 2x3x1,you could pick up additional profit due to the effect of sticky delta...

Here is a quick seat of the pants way of looking at it. Look at the MSFT options expiring next week.
The 300 vs the 330 calls trade 1x3 for apx even. Now look at the 280 vs the 302.5 1x3 call spread..Where does that trade??



LM3886 said:
Yes. I searched in Derman's paper for "skew Delta" but couldn't find a match. Does it mean one of these?
More...
 
taowave said:
Here is a quick seat of the pants way of looking at it. Look at the MSFT options expiring next week.
The 300 vs the 330 calls trade 1x3 for apx even. Now look at the 280 vs the 302.5 1x3 call spread..Where does that trade??
More...
I see. The 300/330 1x3 call spread will gain more in sticky Delta than in sticky strike as the underlying goes up to 300.

So skew Delta is an approach to consider skew and sticky Delta together, not a calculated value? But there is also the caveat that sticky Delta is an approximation and not the true case (which would be difficult to model).
 
I am aware of it and I factor it in to my choice of strikes and ratio..

I certainly do not compute a residual delta and hedge against it....

But I also wont be short it unless vol is ridiculously low

Hopefully,its an added bonus :)





LM3886 said:
I see. The 300/330 1x3 call spread will gain more in sticky Delta than in sticky strike as the underlying goes up to 300.

So skew Delta is an approach to consider skew and sticky Delta together, not a calculated value? But there is also the caveat that sticky Delta is an approximation and not the true case (which would be difficult to model).
More...
 
taowave said:
I am aware of it and I factor it in to my choice of strikes and ratio..

I certainly do not compute a residual delta and hedge against it....

But I also wont be short it unless vol is ridiculously low

Hopefully,its an added bonus :)
More...
I see. How do you model the residual vol change in addition to sticky Delta? I find it very challenging because given the same underlying movement, the vol change is quite random at different times and in different stocks. Sticky Delta seems to be a rough approximation only.
 
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