Invest Without Emotions
A lot of thick blue squares mean that positive correlations are high. Red squares mean negative correlations are high. Whites are the doldrums.
We saw earlier how infrequent but large losses in the short-call butterfly strategy can wipe out all the past profits earned. To figure out a stop-loss mechanism, we plotted individual expiry-to-expiry butterflies to find out how each one of them behaved. This data is available in the appendix below.
The stop-loss is set at 10 points (x lot-size) for the butterfly. But this kicks in only 10 days before the contracts expire (see how it gets “pulled” here.)
Here’s the month-over-month returns of a mechanical short-call butterfly strategy with stop-loss:
Here’s the month-over-month returns of a mechanical short-call butterfly strategy without stop-loss:
Because of the stop-loss, the frequency of losses increases but their magnitude decreases. However, stop-losses were hit about half the time.
Applying a stop-loss to a mechanical expiry-to-expiry short call butterfly strategy on the NIFTY seems to enhance returns by cutting out infrequent but large losses. However, the frequency of wins seems low given that only two out of 5 years resulted in net profit. If you did not use a stop-loss, you would have larger gains and would have had more positive years. However, losses in 2010 and 2012 were enough to wipe out all profits and more.
https://www.scribd.com/doc/271141815/Nifty-Butterfly
So far, we have focused on the NIFTY for selling butterflies (Part I, II, III.) How would this look on the BANKNIFTY?
First, let’s have a look at the 30-day rolling returns of the CNX BANK Index, from 2010 to the present, the whole population:
Median: 1.79%
2014-present:
Median: 2.21%
Beginning of 2015-present:
Median: flat
Currently, the index is around 18700. That means a 100-point move translates to 100/18700 ~0.5%
If we do the same back-test we did to the NIFTY, this is what we find:
As with the NIFTY, the trade makes money if you know how to cut your losses. However, when the trade is live, how do we know what the future volatility of the underlying is going to look like? Without risk-management, a short-call butterfly strategy will encounter out-sized losses that wipe out all prior incremental gains.
We saw that the NIFTY’s median move over a 30-day period is over 1% and that is all that is required to make a short-call butterfly strategy profitable. Let us now do a quick back-test to check if it is indeed the case.
Here is the short-call butterfly back-test from 2010 through now. You basically sell the closest expiry butterfly at each expiry (click to embiggen):
While it is true that a 1% move in the NIFTY results in a profitable trade, there are instances where the NIFTY doesn’t move +/-1%. When the NIFTY ends flat, you end up losing all your prior profits. Understanding what drives NIFTY to move is key to managing your risk while running this strategy.
In our earlier post, we saw how selling NIFTY butterflies has been profitable this year. To understand why, let’s have a look at the rolling returns of the NIFTY.
Here’s the 30-day rolling returns of the NIFTY, from 2010 to the present, the whole population:
Median: 1.57%
2014-present:
Median: 2.18%
Beginning of 2015-present:
Median: -1.08%
For a short-call butterfly to be profitable, NIFTY has to expire away from the either of the wings. Each wing is 100 points away. With NIFTY at 8500, that’s a 1.12% move. Whereas back when NIFTY was around 6000, this trade would require a 1.67% move to be profitable. So as the NIFTY rises, if they don’t widen the distance between the listed strikes, your hit ratio with selling butterflies will increase. However, the total profitability will decrease because everybody will think this way.
If NIFTY continues to exhibit the same pattern of returns, a rising NIFTY will make selling butterflies more profitable.