Butterfly Backtesting Ideas (Part 2)

I’ve been going through my “drafts” folder this year trying to finish partially-written blog posts and get more organized. Here is a one-off post whose sequel simply did not get completed. As I have said before, in the longshot case that someone out there could possibly benefit from any of this, what follows is Part 2 from June 15, 2017.

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Everywhere I look people seem to be doing butterflies of some sort so I’m really interested to find the attraction.

I would like to do a backtest of the flat iron butterfly but before that I’d like to do a typical, symmetric butterfly. I’d like to place this above the money because of all the talk of doing the asymmetric in order to balance NPD, which is normally negative at inception on an ATM symmetric butterfly due to vertical index skew. Rather than take on a boatload of additional risk in the form of asymmetric wings (embedded vertical spread), centering the trade above the money will offset natural negative delta at trade inception.

How far above the money?

If I’m looking at 10-point RUT strikes then going below the money could be 1-10 points, which is 0.25% to 2.5% with RUT at 400 or 0.071% to 0.71% for RUT at 1400. The former is much larger but if the average move (ATR?) is much smaller in case of the former (it should be) then everything should be fine.

One thought that comes to mind is that IV might tell me whether we’re in a relatively volatile (high ATR) or channeling (low ATR) market, but it’s possible that all incidents of RUT < 400 are relatively volatile whereas higher prices may lack volatility on a relative basis. This is true because of the limited sample size of trading days < 400. I should do a study of # days with RUT price between certain ranges (maybe look every 100 points) and check average IV and IV SD.

How wide should my wings be?

Part of me would like to take a fixed wing width and use it throughout. The problem I see is that the percentage will differ greatly if the index is at 400 vs. 1400. This is an argument for using a constant percentage. Of course, I can take whatever width and multiply by the appropriate number of contracts to somewhat normalize margin requirement (MR). My concern here is that a fixed width might be relatively wide with respect to ATR for some butterflies and relatively narrow for others. In other words, if a fixed width ends up being a minimal move in some markets vs. a huge move in others, then maybe I should use another indicator to tell me what width best fits a certain market and then adjusting total risk (MR) by adjusting position size.