The Best Condor/Butterfly Technical Indicator

www.VolatilityTimer.com [email protected]

Disclaimer:

Steve Lentz, Volatility Timer, and Credit Spread Associates, Inc. are not Registered Investment Advisors, and all our research information is presented in the context of education and not personalized financial advice. Options trading can result in unlimited risk, and this should be fully understood before any options trading venture.

Dear Index Options Trader, One of the great lies foisted on options trading students over the years is the notion that index butterfly and condor positions could be successfully placed at any time with high probabilities of success without any regard for the underlying market condition. Choppy markets, bull markets, bear markets…it didn’t matter. My name is Steve Lentz, and I have over 20 years of experience in the options trading world as a trader, researcher, mentor and curriculum author. Over that time, I grew frustrated with all the technical price analysis knowledge available for taking bullish or bearish positions, but how little understanding there was of applying this knowledge to trading market neutral strategies like index options condors and butterflies. Years of research and hundreds of intertwined indicators later, I developed a methodology called Volatility Edge Analysis which helps crack the code of successful entry timing for these positions. With these strategies, the wrench in the spokes lies with the VIX. It can fluctuate greatly and has huge impacts on outcome. Further, as a single number, the VIX by itself does not factor in the vertical volatility skew displayed by index options. Volatility Edge Analysis accounts for this. In this report, I will explain Volatility Edge Analysis and walk through how best to find a single indicator that gives a green light for placing butterflies or condors.Our walkthrough will include: 1) A review of Condors and Butterflies 2) The Implied 30-Day Move Derived from the VIX and SKEW 3) The Subsequent 30-Day Actual Move of the index 4) How Favorability of a daily bar stems from the relationship of Implied and Actual moves 5) How we measure the distribution of Favorable and Unfavorable daily bars 6) How we determine the range trading edge by comparing the baseline distribution of Favorable bars to the distribution of Favorable bars for those filtered by various indicators. This will include a determination of the best indicator from among several candidates.

My research service uses this same Volatility Edge Analysis methodology to confirm clients’ ideas for using technical analysis in seeking an options selling edge. If, after reading this report, you are interested, please email me. My rates are reasonable and all research is confidential.

Best Regards,

Steve Lentz [email protected]

Range Trading with Condors and Butterflies

Many traders come to the options markets due to the promise of being able to make money no matter which way the market moves. They often are introduced to the concept of selling option premium through these two approaches; the iron condor and butterfly.

To answer the question, “Is now a good time to initiate a Butterfly or Condorcampaign?”, it’s important we first understand the nature of these strategies and why they make and lose money.

1) Both approaches profit when the ensuing move of the underlying index is of a lesser magnitude than that implied by the price of the options. 2) Both approaches incur risk of loss when the ensuing move of the underlying index is of a greater magnitude than that implied by the price of the options. Position adjustments are often needed when this occurs.

Let’s quickly review the nature of a Condor and Butterfly using examples in the SPX.

Figure SPX Ratio Iron Condor

Figure 1. Ratio Iron Condor: a 5-lot Bear Call Spread plus a 10-lot Bull Put Spread

An Iron Condor consists of an out-of-the-money bear call credit spread combined with an out-of-the-money bull put credit spread. Both positions earn the full credit if, at expiration, the index lies in between both short strikes. The position of the short strikes and the contract size of each position can be altered so as to manipulate the directional bias. Figure 1 above displays a Ratio Iron Condor with the call side having half the contract level of the put side.

Figure 2. SPX Ratio Iron Condor Graphic Analysis

It’s often said that, ”A picture is worth a thousand words” and this is especially true in options trading. Figure 2above shows a graphic analysis of the risk and reward of the same SPX RatioIron Condor position.

 The X-axis represents the index level  The Y-axis represents the profit or loss level.  The 3 lines within the grid represent timeframes related to days-to-expiration (DTE)

The main point to notice is that the position makes money at expiration if the SPX lies between 2812 and 2994. Speculating the SPX will do so is called Range Trading. The trader wants the index to stay within a range and not drift too far in either direction. If it does, and no adjustments are made, then the position can lose as much as $7925 to the downside and $2925 to the upside.

Figure 3. Profit Zone for the Ratio Iron Condor is in green

The OptionVue options analysis software produces a Profit Zone tool that displays colored regions of profit and loss. Figure 3 above clearly shows why the approach is called Range Trading.

Figure 4. SPX Broken Wing Put Butterfly

Another Range Trading approach is called the Broken Wing Put Butterfly. Rather than the long strikes being equidistant from the short strike, this method will alter those distances so as to manipulate the reward to risk ratios and directional bias as well. Figure 4 above shows an example.

Notice that the in-the-money long strike at 2910 is 35 points away from the short strike of 2875, and the long strike at 2820 is 55 points away. This difference is what make this a “broken wing” butterfly.

Figure 5. Broken Wing Put Butterfly Graphic Analysis

The Graphic Analysis of that position is displayed in Figure 5 above. Here, at 24 DTE, the position makes money if the index lies between 2831 and 2963.

With either strategy, though, what happens when the index movestoo strongly in one direction? You have two choices: 1) remove the position and accept any loss, or 2) adjust the position in some manner and embark on a campaign approach to range trading. This is where things can get very complicated. Some books and education programs teach extremely complex methods while others advocate for simpler approaches.

To learn how to adjust condors and butterflies, just search the web for the terms “options condor adjustments” and “options butterfly adjustments”. The list of sites and ideas along these lines is endless. Again, our report concerns the proper timing of campaign entries.

Regardless of what campaign method you employ, range traders do best when the market moves at an actual volatilitylevel that is lower than what is being implied by the options’ time premium. Range traders should seek market Copyright 2021 Credit Spread Associates, Inc. environments where it’s more probable that actual volatility will be less than the implied volatility, and consequently avoid market environments where it’s more probable that actual volatility will be higher than the implied volatility. Analyzing these volatilities to obtain a range trading edge level is calledVolatility Edge Analysis which is covered in the following five concepts:

 The Implied 30-Day Move Derived from the VIX and SKEW  The Subsequent 30-Day Actual Move of the index  The Favorability of a daily bar stems from the relationship of Implied and Actual moves  Measure the distribution of Favorable and Unfavorable daily bars  Determine the range trading edge by comparing the baseline distribution of Favorable bars to the distribution of Favorable bars for past occurrences of the current market condition

Let’s take these one at a time and progress toward an understanding of the range trading edge level.

The Implied30-Day Move Derived from the VIX and SKEW

The Chicago Board Options Exchange’s (CBOE) Volatility Index, ticker symbol VIX, is a measure of the stock market's expectation of 30-day volatilityimplied by S&P 500 index call and put options. Butthe volatility implied by these options vary greatly from strike to strike.

Figure 6. Vertical Skew Reflected in MIV (Implied Volatility of the Midpoint Between Bid and Ask): August 31, 2018

This variance results in a vertical volatility skew whereby the out-of-the-money (OTM) calls have a much lower implied volatility than the OTM puts. See Figure 6 above. This means the implied move to the upside is of a lower magnitude than the implied move to the downside. So, to understand the expected move of the index in the context of selling options premium, we need to recognize this asymmetry and calculate both an “Upside VIX” level and a “Downside VIX” level.

Downside VIX -- As it turns-out, the VIX itself is a good estimation of the downside volatility in that it also happens to approximately reflect the implied volatility of the 30-day put contract one standard deviation out-of-the money.

Upside VIX -- Fortunately, the CBOE publishes a figure to helps us in this regard. It’s called the CBOE SKEW Index, ticker SKEW, and it essentially measures the slope of the vertical skew displayed in Figure 6.

Figure 7. Separated implied volatility levels for August 31, 2018

A full explanation of the SKEW is available on the CBOE’s website. Suffice to say that the algorithm for using the SKEW to derive the upside VIX levels is complex and proprietary. Figure 7 above displays an example from August 31, 2018 when the VIX was at 12.9, the calculated Upside VIX was 9.6.

Separating out the upside VIX more precisely reflects the true nature of volatility implied of the index options.

Figure 8. SeparatedVIX Levels Converted to Percentage Moves Up and Down

In selling options premium, range traders are very concerned with the actual movement of the index after starting the campaign, i.e. what percentage of move it makes to the upside or downside. To compare apples to apples, it is required that we convert the separated VIX levels to the corresponding percentage moves implied to the upside and downside. Figure 8 above displays this conversion.

Understand the Subsequent 30-Day Actual Move of the Index

Now that we understand the implied percentage moves to the upside and downside, it’s time we now turn our attention to the actual move of the index moving forward. From any close, we want to know if the maximum move, either up or down, was beyond what was being implied by option prices at the time.

Figure 9. Example of the highest actual move up of 2.6% being less than the implied of 4.1%

In index daily price charts, we look 21 bars (30 calendar days) into the future to ascertain the maximum percentage move that occurred in either direction. We then compare this amount to the percentage move that was implied at the time before the move began. Figure 9 shows an example where the actual maximum move upward of 2.6% was less than the SKEW-adjusted implied move upward of 4.1%. Range trading would have been easier during this stretch.

Figure 10. Example of the largest actual move downward of 12.8% being more than the implied of 5.6%

Copyright 2021 Credit Spread Associates, Inc. When an index drops fast, it can sometimes move with a far greater magnitude than the move implied by options prices. Figure 10 shows an example where the actual move down of 12.8% was much greater than the implied downward move of 5.6%. Range trading would have been difficult during this stretch, and it is stretches like this that we wish to avoid.

Favorability of a daily bar stems from the relationship of Implied and Actual moves

We will paint those index bars red which had subsequent moves greater than the implied, and label them “Unfavorable”. Bars that resulted in actual moves less than the implied will be painted blue and labelled “Favorable”. Range trading campaigns started on these Favorable bars would more likely have been successful.

Figure 11. Favorable Bars for Range TradingColored in Blue…Unfavorable in Red

Notice that an Unfavorable bar can be red whether the actual maximum move was up or down. In Figure 11above,red bars in December were Unfavorable due to the ensuing large downside move. The red bars in mid to late February were Unfavorable due to the large upside move which carried into March.

Measure the distribution of Favorable and Unfavorable daily bars

Now that we can ascertain whether a bar was Favorable or Unfavorable for range trading, let’s now determine how often each has occurred. After all, if most index bars are Unfavorable, then we probably should not sell option premium through range trading in that particular market. But as we will see, in the case of the SPX, more than half the bars have been Favorable ones.

Figure 12. Baseline SPX Favorable Bars, Since January 2000, is 58%

Indeed, since January of 2000, roughly 58% of all of the daily SPX bars (4813) measure out as being Favorable for range trading.This 58% does NOT represent an edge in and of itself. This means you have a 58% random chance of landing on a favorable bar with nothing else considered. This figure, instead, represents a baseline from which we will measure a positive or negative trading edge moving forward.

Determine a technical indicator’s range trading edge by comparing the baseline distribution of Favorable bars (58%) to the distribution of Favorable bars for periods filtered by the indicator.

Let’s begin with a 70-day simple moving average (70-SMA), and look only at bars that closed above it.

Figure 13. Of those SPX bars over a 70-SMA overlay, 63% were Favorable.

Notice in Figure 13 above that by considering only bars closing above the 70-SMA (3061), we filter out many red (Unfavorable) bars in late 2018 and early 2019, which were beneath the moving average. Also see that in 2016 many Unfavorable bars underneath the moving average were filtered out as well. Finally, notice that 63% of the bars above the 70-SMA were Favorable.

70-SMA Edge

If 63% of the bars above the 70-SMA were Favorable, and the baseline for all bars is 58%, then the trading edge for this indicator is 5% (63-58%). In the diagram below, we will consider many more moving averages.

Figure 14. Results of filtering for the Close being above a moving average. The 70-SMA had the highest edge.

The column marked Hst Bars refers to the baseline number of Closes that occurred from January 2000 to March 11, 2019. The column marked Hst % Fv displays the baseline percentage of Favorable Bars from the baseline Closes. Past Occ refers to the number of Closes filtered-in from the indicator. % Favor displays the percentage of filtered-in Closes that were also Favorable. Of course, Edge displays the difference between % Favor and Hst % Fv.

Now let’s look at other indicators and conduct a more general survey.

Stochastics

Stochastics measures the position of the current close relative to the recent range of prices. This position is measured between 0-100 and can be trending up or down. The settings are “15-3-3”, meaning the lookback period (%K) is 15 days (smoothed with a 3-SMA) and the trigger line (%D) is a 3-SMA.

Figure 15. Four ranges of Stochastics consideration using a setting of 15-3-3

We will divide the Stochastic possibilities up 4 ways: trending up within a range of 0-50, trending up within a range of 50-100, trending down within a range of 50-100, and trending down within a range of 0-50.

Figure 16. The Range Trading Edge is negative when %K is between 0-50.

As you can see from Figure 16 above, the range of %K seems to coincide with a positive or negative edge. The range trading edge is positive when %K is above 50, but negative when it is below 50.

Now let’s look at another indicator created by Welles Wilder.

ADX

The ADX is a trend determination indicator that extrapolates trend strength from derivatives of the Average True Range.

Figure 17. An ADX under 20 correlates with historically choppy price behavior

The trend is considered strong when ADX is at least above 20. Some analysts prefer 25 or even 30 or more. Also, a rising ADX corresponds with a strengthening trend and a declining ADX corresponds with a weakening trend.

Figure 18. The ADX edge levels are mostly negative

As seen in Figure 18 above, using the ADX as a condor/butterfly filter offers no real range trading edge.

Finally, let’s look at Price Action

Price Action

Some options trader educators have advocated for “down days” as a precursor to successful condor and butterfly trading. The premise is that, with the indexes, implied volatility tends to rise on days when the market closes down. This extra time premium means more profits should the market channels nicely, and also more of a buffer in case the index goes crazy and moves a lot.

For our purposes, we will use the following definitions for price action:

Upswing (higher high and higher low) Downswing (lower high and lower low) Inside (lower high and higher low) Outside (higher high and lower low)

Figure 19. Price Action Range Trading Edge Results

Volatility Edge Analysis of Price Action reveals in Figure 19 that Downswing Bars and consecutive Downswing Bars, by themselves, do not yield a range trading edge. In fact, consecutive Downswing Bars yield a negative edge. Indeed, the Inside Bar shows the most positive result.

The Best Single Condor/Butterfly Indicator

Of all the indicators measured above, the 70-day simple moving average (70-SMA) yields the highest range trading edge for the SPX options. Requiring the Close to be above this level gives a 5% edge over just randomly selecting a day.

But this leads to two important questions:

1) What would the edge be if you combined the 70-SMA with another indicator? For example, the positive edge from the Close being above the 70-SMA could be offset if the Stochastic %K was between 0 and 50. 2) What would be edge be you combined a SMA with Stochastics and also added-in the Price Action as well?

The answer to both questions is that the resulting edge figure would be far more refined. In fact, this is what my Volatility Timer research service offers.

Volatility Timer Research Service

If you have ideas for combining indicators, price action, or both in any combination in search of an options selling edge, my Volatility Timer Research Service will run an analysis and generate the edge levels that can confirm your ideas. My rates are reasonable and all research is strictly confidential. If your ideas can be coded into MetaStock, then I can help you. My studies accommodate SPX directional-neutral strategies like condors and butterflies, as above, and also bullish leaning strategies like bull put spreads. If interested, please inquire at [email protected].

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