Butterfly Skepticism (Part 3)

On my mind this morning is skepticism regarding the protective put (PP).

I have seen the PP lauded by many traders as a lifesaving arrow to have in the quiver.

One trader described this to me with regard to a butterfly trading plan. Part of the plan provides for the following adjustment:

1. If NPD is at least 10 with market at least -1.6 SD intraday then record NPD.
2. Buy PP(s) to cut NPD by 75%.
3. On a subsequent big move, if NPD again reaches value recorded in Step 1 then repeat Step 2.
4. If market reverses to the high of purchase day, then close PP(s) from Step 2.

Upon further questioning, I got some additional information. He learned it from a guy who claims to have “mentored” many traders. The mentor (teacher) claims to have seen many lose significant money in big moves and therefore recommends this to avoid windfall losses. The teacher has shown numerous historical examples where this adjustment would keep people in the trade (not stopped out at maximum loss) and often wind up profitable. Further prodding revealed uncertainty over whether these “numerous” examples amount to more than a handful of instances. Of the several times the adjustment has been presented, he acknowledged the possibility that many could have been repetition of the same [handful of] instance[s]. He is uncertain whether anyone has presented big losing trades more than once.

Much of this casts doubt over the sample size behind this adjustment. We certainly wouldn’t want to fall prey to that described in this this second-to-last paragraph.

As described in this third paragraph, the PP is simply an overlay added later in the trade. This strategy also has its own catchy name and is marketed. In order to backtest, we could study the profitability of long puts purchased on days the market is down at least 1.6 SD (also explore the surrounding parameter space as discussed in the fourth complete paragraph here).

From a backtesting perspective, intraday is a huge wrinkle. Technically, I’d need intraday data to identify exactly when the market was down 1.6 SD in order to purchase the PP at the correct time. As mentioned in the second-to-last paragraph here, this is arguably another reason why certain trading plans cannot be backtested: data not available.

I will continue next time.