Convention for butterfly trades
Hi All,
A newbie question: what is the market convention while qouting and trading butterfly spreads?
This link mentions 4 calls: http://en.wikipedia.org/wiki/Butterfly_(options)
and this mentions a strangle + straddle combination:
http://www.riskglossary.com/link/options_spread.htm
I know because of put-call parity either one will give the same payoff, but generally in the market how is a butterfly priced/treated?
Do you consider both calls & puts (i.e. straddle/strangle combo) or only look at just calls as Wikipedia says.
I will include the standard disclaimer that I am very new to this, so please bear with me if this is very basic.
-Steve
The traditional textbook butterfly has the strangle notional as two times that of the straddle notional - hence the pay off diagrams are flat once the underlying moves past one of the strangle strikes (if you purchase the butterfly you refer to the strangle/the 'wings'). However, in the broker market butterflies are actually traded as such: - The strangle vol is computed by finding the 25d put and call vols and then solving for the same implied vol that keeps the total premium unchanged (typically puts trade over calls (the 'skew'). This is the broker strangle, as opposed to the smiled strangle which is just the arithmetic vol average of the 25d put and call. - The notionals of the strangle are chosen such that the butterfly is vega-neutral so the notional of the wings is more than 2x that of the ATM, making the payoff diagram a W shape instead.
There are all sorts of flies... The straddle - strangle thing is normally called an "iron fly" in my neck of the woods.
He's looking at it from the FX perspective, so everything traded in the broker market is a market strangle. They are always done B-S vega neutral Strangle vs Straddle (so in reality there is a vega on it when considering the smile, you can do it smile vega neutral, but it's not super common). Convention on anything vega-neutral is to say # of option 1 by vega equivalent of option 2. Flies are DNS by vega equivalent of the strangle. So if you bought the butterfly in 100/v, you would sell 50 a/l of DNS and by vega equiv strangle.
Keep in mind when you trade a market strangle, you use a common vol to solve for the strikes you will actually trade. As such, even if you trade a 10d butterfly, the strikes you actually trade are unlikely to actually be 10d on smile (read with skew).
They are quoted as Common vol strangle - DNS vol (or ATMF for long dated). So if you bought USDCAD 1y 10d strangle at .9, you then agree an atm vol (let's say 6.6), so the strangle common vol will be 6.6+.9 = 7.5 which will then be used to plug into B-S to get the strikes.
Bonus questions: Why do you need to agree a vol? How does it impact your trade? If you bought the fly, likely what do you want the vol to be, high or low?
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