When I am mentoring, the most common question I get is: “Implied volatility has done (insert action). What trade do you think I should put on here???” I will also have students say: “The market moved (insert amount) in the last week, what kind of trade should I put on?” While there is no true ‘right’ answer I do believe there often is a ‘best answer’. Most of the time my students will find what I believe to be that ‘best answer,’; however, many do get snagged.
One of the most common trade decisions that students have trouble with is when to short an iron butterfly instead of an iron condor and vice versa.
I can understand the difficulty because the trades have many similarities. Iron condors and Iron Butterflies are both short Vega, long theta trades. Iron butterflies and iron condors perform best when the underlying has a limited range. Neither trade deals with intermonth skew sometimes called horizontal skew. So how does a student figure out the differences? The trader must learn the difference between an implied volatility trades I call a “pure Vega” trade and a statistical volatility trade I nicknamed a ‘gamma’ trade.
Implied volatility is the true driver in most models. The higher implied volatility is the more expensive an option will be. As it falls, the options will get cheaper. When the market falls consistently, and quickly implied volatilities will typically increase very quickly. For instance, during the last market turnaround at the end of October, the Russell 2000 November option’s implied volatiles increase 20 percent in less than a week.
This was due to two things:
This causes a problem for traders. Certainly I want to get short Vega, but I don’t want to deal with the speed of the market. This is why the iron condor makes sense, relative to all other trades it will allow me to sell front month options, sell Vega, and avoid front month speed. During the November month, at the tail end of the volatility increase I could enter a relatively conservative condor selling the 15 delta options. One week later I would have made 20% on the Iron condor and be looking to exit.
This trade far outperforms an at the money butterfly placed at the same time.
The reason? The condor is sensitive to the Vega, and less sensitive to the actual movement of the underlying. It is a ‘pure Vega’ play.
I don't view the position as a long term trade. You get in - sell Vega - and get out!
Typically, this play will only take a few days to work. It is very important not to hold the trade once implied volatilities normalize. A ‘pure Vega’ play loses its ‘edge’ once panic and fear leave the market, and option prices become more efficient and the wings of an option chain will deflate. Once prices become efficient the iron condor is now open to the ‘random walk’ of the market place.
Any time I see a huge increase in implied volatility based on a strong speedy move, I am looking to enter this trade.
A ‘gamma’ trade, like an iron butterfly, works very differently. While still short Vega, it is far more sensitive to movements in the underlying. This trade does not perform well when placed at the very peak of implied volatility. As stated above, an ATM money butterfly was outperformed by a condor when both placed at the peak of the implied volatility spike. Unlike the condor, the butterfly is a victim of the speed of the market.
When implied volatility peaks, it is typically met with a lot of pressure to the downside. Once the pressure is released, the market will often snap back. During the snap back, the underlying can gain back a large portion of what it lost in a short period of time, and implied volatilities will fall although typically remain somewhat inflated. Even with the drop in volatility, the butterfly loses too much value from the market moving away from its short strike- the gamma of the trade killed it.
So when is the best time to enter a ‘gamma’ trade?
Once the market has snapped back, you'll be out of the ‘pure Vega’ zone and enter into the gamma zone. Typically after implied volatilities fall they will remain elevated, even though the speed of the market place has disappeared. This is because many traders still fear a major move.
This can be the perfect time to enter a trade.
Implied volatilities will still fall, but the market will lack movement associated with the initial drop in implied volatilities. Thus, when the condor is coming off, the iron butterfly is going on. In the case of the November contract, you could have entered an ATM butterfly the day after exiting the iron condor. One week later you would have been up 10%.
Why? What happened?
This allowed you to collect a very large amount of theta in a very short time. You sold gamma for more than the market was moving. Like the ‘pure Vega’ trade, this is not a long term trade. Once implied volatiles fall back another 10%, it is time for you to exit the gamma trade.
Any time a trader loses the perceived ‘edge of the trade, it is time to call it a day.
It will almost never be this easy to trade. Going from ‘pure Vega’ to ‘gamma’ trade is almost never smooth. Picking tops and bottoms is very difficult, but seeing an example like this can give you some ideas on trade selection.
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