Below-the-money butterfly spreads sized by volatility regime

Redesigning the book after short-premium losses

Recurring large losses were attributed to the combination of short gamma and short vega while collecting time decay. After 2008 the workflow was redesigned to seek theta with sharply reduced gamma and vega exposure.

Conventional butterflies typically place the short strikes at the money. This construction opens as a below-the-money butterfly with negative delta and neutral or positive gamma.

When implied volatility is low, the risk method will sacrifice theta collection to keep gamma near zero and to keep short vega much smaller than in a conventional short-premium butterfly.

Classify the regime before choosing strikes

A one-year volatility-index history is split into four implied-volatility quartiles, 0-25, 26-50, 51-75, and 76-100, to label the regime as low or high implied volatility before a structure is chosen.

Put skew, the implied-volatility gap between far-below-the-money puts and at-the-money puts, is read with that label. The archive pairs low implied volatility with steep put skew, and high implied volatility with normal-to-flat put skew, before the butterfly is opened.

Two opening constructions

In the low-implied-volatility, steep-put-skew regime, a symmetrical below-the-money butterfly is paired with a deep in-the-money call of at least 60 delta, using 100-point wings on monthly SPX. That call is the delta overlay used to reshape net delta while the butterfly remains the core spread.

In the high-implied-volatility, normal-to-flat put-skew regime, a below-the-money put broken-wing butterfly is used with no long call. The construction typically places the upper strike 25 points above spot, the right wing 75 points above the short strike, and the left wing 100 points below it, which leaves more negative vega.

Both constructions are preferably opened on down days when implied volatility is rising. An iron butterfly, a short put credit spread under a short call credit spread, may replace an all-put book to raise credits and conserve capital.

Cycle limits and the same-day risk line

The defensive profile is described as negative delta with a relatively flat same-day profit-loss line. That same-day risk line is used to judge whether the open book is still defensive before any later adjustment, so a decline must travel through the profit zone before reaching the risk zone.

The process uses monthly SPX and allows at most one or two adjustments per cycle. It states a 5-to-10 percent gain objective and a loss bound under 5 percent on a 50000 book. Exit is preferred near 14 days to expiration to avoid rising gamma, and the next cycle starts with 60 to 80 days remaining.

Adjustments follow the greeks

After entry, adjustments follow the greeks rather than a fixed rule list and may include condor overlays, strike shifts, or added long options. The first size control can be a full or partial exit near a 10 percent gain, for example reducing a 6-by-12-by-6 butterfly to 2-by-4-by-2.