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3 Steps For Timing Your Butterfly Trade Entry – $RUT $RVX

Timing markets is hard, really hard.  Part of why I like trading non-directional option strategies is that they reduce my need to time the market well.  I’m not horrible at market timing, but I’m definitely not gifted either and, for options trading, that’s good enough.

The steps below outline how I assess the market when I’m getting ready to enter a Butterfly trade.  Note that I only trade this style of Butterfly in the Russell 2000 ($RUT), but some traders like to use other cash settled indexes.

In this example, we’re looking at an income Butterfly positioned 10-20 points below the money giving it a slight bearish bias (short delta).  The Butterfly uses long wings placed 50 points on either side of the short strike and I also pick up an $IWM call to hedge the upside.  My preferred entry window is 50-55 DTE and I’m willing to enter as early as 60 DTE or as little as 45 DTE.

1.  Define your window of opportunity

When you’re new to options income trading, it’s acceptable to put on trades with an exact number of days to expiration.  However, as you become more familiar with options trading, you start to realize that your initial greeks can give you either an immediate small profit or immediate small loss.  In other words, when you open the trade it has a slight directional bias.

The chart below shows the 45-60 day window of time for trading the March 2015 expiration cycle.  In the entry window below, you could have chosen an initial short strike anywhere from 1190 to 1150.  For March expiration, a higher short strike would have been easier to adjust on the upside than a lower strike.  Trust me, I started March with a short strike at 1160!

RUT Butterfly Options Timing

2.  Assess the market

Once you’ve determined a window of time for placing the trade, you need to look for your preferred conditions.  Since this Butterfly has a slight bearish bias, we want to enter the trade when the market is likely to decline slightly after entry.  While it’s difficult to know for sure when the market will decline, using a short term overbought/oversold indicator can help.

One of my preferred overbought/oversold indicators is the Relative Strength Index (RSI) with a value of 4 days rather than the standard 14 days.  We’re not trying to get in at the exact top, but we don’t want to jump into a slightly bearish trade right before the market bounces.  In the image below, you can see the more overbought days in the entry window when RSI(4) came up to around 70.  Simply avoiding trade entry on a day when RSI(4) was under 50 would have helped with timing.

RUT Relative Strength RSI

3.  Cast your line and get some protection

Once you’ve decided that the market is short-term overbought, it’s time to place the trade.  I like to position my short strikes 10-20 points below the money.  My general market opinion influences how close to the money I place the short.  If I’m more bullish, I’ll keep the short closer to the money.  If I’m more bearish, I position the Butterfly further away.  That being said, a slight difference in the initial short strike won’t make or break the trade . . . your adjustments will.

After the Butterfly is purchased, I buy a long $IWM call to hedge the upside delta.  The ratio I use is 1 $IWM call to 1 $RUT Butterfly.  I’m comfortable leaning a little short delta when the trade begins, but I don’t like being heavily short delta.

Beware!

While the steps above will certainly get you into a trade, they will not guarantee a successful trade.  Butterflies usually have a narrower probability window than Iron Condors and, consequently, require more trade management.

In other words, you need to have a plan for managing your Butterfly after the trade is placed.  If you don’t have a plan for managing the trade prior to entry, you’re asking for trouble.

Let me know in the comments below if you want to hear more about managing an income Butterfly once the trade is open.

One last thing:  The rules above are great in theory, but the real challenge is trading the position.  I traded the March expiration with a starting strike of 1160 (very poor initial positioning).

This article talks about my March 2015 expiration trade and the adjustments I made.

 

  • kapil1022

    Hi Dan, Yes I would appreciate a discussion on managing the butterfly trade. Also, when I set up a quote for butterflies, the bid ask spread is huge…6 points. What kind of fills can you get and are they consistently available? Thank you, Kapil

    • Hi Kapil. Good to hear from you. Thanks for the validation and I have more Butterfly information coming so you’re in luck.

      The prices I see for Butterflies in the RUT swing pretty big at times. I usually watch the mid price of the spread for a few minutes and then start putting in orders below the approximate mid price. I move up my bid depending on what happens with the price and the market. Essentially, I’m trying to get a sense for where the market is really trading. There might be a more efficient way to accomplish what I’m doing, but I like to pay as little as possible for the Fly and I’m willing to spend some time working get a good fill.

      The price I actually pay varies. For a Butterfly with 50-55 DTE with 50 point wings I’ve paid anything from 9.35 to over 11. The challenge is that the price depends on volatility and the moneyness of the short strike. Closer to the money = more expensive. Let me know if that raises any other questions. Thanks.

      • kapil1022

        Thanks for the reply Dan. My concern is when I am trying to get out of or adjust a trade. Will the market makers be there without taking a piece of my hide! You seem to be getting filled reasonably well. Is that still true when volatility takes off like now?

        • In my experience, the best way to avoid getting bad fills is to be patient. Additionally, it helps when you avoid getting into a panicked situation and feel like you need to adjust immediately.

          Let’s think about yesterday morning for the volatility question. When the market opened, it gapped down huge. I could tell just looking at TOS that the options prices were totally out of whack and VIX wasn’t even showing the right price. I don’t even attempt to get filled when the conditions are that crazy because I expect to get horrible fills. Yesterday I closed things out, but I waited until things had normalized a little bit (after an hour or so). Volatility, in and of itself, doesn’t seem to impact my fills, but panic probably would.

          I am still getting filled well. I took off my 1110/1160/1210 Butterfly today and moved it down to 1070/1120/1070. I closed the trade for 11.40 or so and bought the new Butterfly for 9.44. I also brought down my IWM call from 119 to 115. I always try to work a limit order slightly below the mid price to see if I can get a couple more pennies out of every trade, but I’ll raise my bid to the mid or slightly above if I’m not getting filled.

  • Klng

    Hi Dan, I’m very happy to discover this great site. Yes, ICs are very popular, but flies are much less understood. Since the first time I’ve traded a fly, I got addicted to it. How to manage the upside really deserves much study. You mentioned buy an IWM call as a hedge. What delta and DTE is it? Do you think an RUT call with smaller delta (equivalent in dollar value to an IWM call) will also work?

    In my study, the most undesirable situation is when the index rises to somewhere between the upside wing and the call strike. Volatility contraction and theta decay both works to hurt the trade. I’m looking forward to reading your other studies.

    • Hi Klng and thanks for the comment. I definitely agree with you. IC’s get all the love, but Butterflies are way more interesting and dynamic. I think part of that has to do with the initial structure of the Butterfly. Specifically, when I trade a Fly, I’m starting with a favorable risk:reward ratio at expiration. That structure allows the position to be adjusted much more easily than a high prob IC with an unfavorable risk:reward. On to your question.

      When I initiate a position, I’m usually positioning the RUT Fly slightly below the money (10-15 points) and placing the long IWM call slightly inside the body of the Butterfly. For example, my October position was initially the 1070/1120/1170 RUT Put Butterfly with the 115 IWM Call. Since IWM is around 1/10th the size of RUT, one IWM call to one RUT Butterfly is essentially a 1 to 10 ratio. I would only use a RUT call if I was trading 10 Butterflies.

      You’re correct that over the life of the trade the T+Zero line will start to drop on the upside. Incidentally, I had that exact situation yesterday. When price is close to the upper part of the Butterfly and the T+Zero begins to fall, I roll up one of the long puts to bring Delta down. See the attached image showing the October position after rolling up a short Put from 1120 to 1130.

      Check out this post as well: http://www.thetatrend.com/consistent-income-butterfly-another-options-trading-strategy-for-smaller-accounts/

      Thanks and let me know if you have other questions!

      -Dan

  • drmark27

    Have you tested RSI(4) to see if it actually does what you think?

    • Hi there,

      Thanks for the comment. The challenge is that I’m not sure what exactly I’d test. The indicator does show short term extremes pretty well, but that doesn’t mean the extreme direction can’t or won’t persist. Additionally, in an uptrend short term oversold conditions tend to resolve to the upside. In a downtrend, the opposite is true.

      The Butterfly is non-directional and it moves with the market if the market trends and my goal isn’t really to pick the perfect entry as much as to adapt to what the market does after entry.

      Dan

  • Roxanne Miller

    I notice these comments are from 2 years ago..are u still in this chat?