Short Volatility Butterflies and the Tail Protection of Long Wings
Summary
The document explains a short volatility butterfly formed by selling an at-the-money call and put while buying lower premium, out-of-the-money call and put options. It frames the trade around implied volatility being high relative to the trader’s expectation for realized volatility. The short at-the-money straddle collects more premium than the winged structure because the wings cost money.
Those purchased wings change the payoff in a large market move: they cap losses that would otherwise be unbounded for a naked short straddle. The trade therefore exchanges some premium income for protection against extreme moves. The answer gives a qualitative payoff comparison, not a pricing model, probability analysis, or empirical evidence. Its description also leaves out details such as expiry matching, strike selection, volatility skew, and how the position should be managed; these affect whether the structure is attractive in practice.
Key ideas
- The proposed butterfly sells at-the-money calls and puts while buying out-of-the-money calls and puts.
- The position expresses a view that realized volatility will fall below implied volatility.
- Buying the wings reduces the premium collected compared with selling only the straddle.
- The wings limit losses from large underlying moves that can make a naked short straddle highly risky.
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# Trading butterfly a long vol or short vol # Trading butterfly a long vol or short vol Sorry for what could be a naive question. When is the right time to trade a butterfly i.e. (buy 10d call and put vs sell atm all notional flat) is it when implied vols are high or low (relative to where your view on realized is)? Just because notional flat butterfly should be a short vol trade you should be doing it when implied vols are high...but then why not just sell the straddle instead? ## Answer by AlRacoon (score 1) https://quant.stackexchange.com/a/58026 You will want to buy the 10 delta calls and puts vs selling the at-the-money calls and puts when implied volatility is high vs your view on realized. You are selling vol which means that your view is that volatility will be lower than that implied by the markets (your maximum profit will be if the underlying doesn't move (no volatility) and you end up collecting the premium from selling the at-the-money straddles vs buying the 10 delta strangles (10 delta options are cheaper than 50 delta at-the-money options). If you just sell the straddles, you will collect more premium since you will not have paid premium for the 10 delta strangles. However, you will have a different risk profile. If you are incorrect and realized volatility is much higher than you sold it (ie the underlying appreciates or depreciates by a lot), your losses will be unlimited with just the short straddle. The cheap strangles protect you from a extreme volatility of your underlying by limiting your losses.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.