Matt Baker |
Welcome to Part 11 of my series on the Greeks. In last week’s article we looked at trades that began with a dominant Greek and how to manage that Greek throughout the life of the trade. This week, we will look at a trade that starts out with each of the 4 Greeks quite dormant. In some cases, it’s not until later in the trade when a particular Greek(s) starts to become active and need monitoring or management.
An example of a trade with all 4 Greeks quite low and dormant at the inception of the trade is a Broken Wing Butterfly. Here are the exact Greeks of a BWB (Broken Wing Butterfly) on the SPY (S&P 500), at inception of the trade, (19 days to expiration).
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Delta
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Gamma
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Vega
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Theta
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-0.33
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-0.04
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-0.42
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$1.30
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We can see here that all the Greeks are quite low, so it could be fair to ask the question “How are we going to make any money here?” The answer depends on where the SPY moves to, whether IV increases or decreases, and how much time passes by. Depending on where the SPY moves to, Volatility increasing or decreasing could be a good or bad thing for the trade. We have seen in previous articles that there can be areas in the risk graph where Vega can be positive and areas where it can be negative. The same applies to Theta in the BWB. In most areas of the risk graph Theta will be positive. The closer to the mouth of the Butterfly the underlying goes, the greater the value of Theta will become.
You can see here that Delta is virtually neutral, presenting no directional risk at this point, but the closer the SPY moves to the mouth and the better (greater) that Theta becomes for us, the greater Delta will become too. What does this mean in a practical sense? Well, Delta starts to become more of a risk (ie we start to lose a little money) as the SPY moves towards the mouth. If the SPY went too far and past the mouth, it would move into the area of the trade where the risk is. But if it doesn’t move that far and is near the mouth of the fly, we would be in a little loss but we would have a much greater Theta now, and as each day passes we would be making money from time decay.
An IV crush in this area would help us, but an IV rush would put the trade into more loss. How much loss you can bear depends on your money management, but if your choice was to stay in the trade, the high Theta would be eating away the time value for you each day, and at an increasing rate, especially closer to expiration, making money for the trade.
Here are the Greeks for this BWB, a week until expiration, with the SPY in the mouth area of the Butterfly, in line with the max profit point.
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Delta
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Gamma
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Vega
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Theta
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10.29
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-3.23
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-$2.64
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$11.05
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You can see how much more Theta and Delta have come to life. This trade is a Put BWB. We know this because Delta is positive. Delta is wanting the SPY to move up, away from the risk area. As long as the SPY doesn’t move down too much, Theta will keep increasing until expiration day. Do you remember from earlier articles which other Greek increases as Theta does? Gamma!. As expiration approaches, Gamma will increase drastically too, meaning if the SPY moved either way, we can lose a lot of the profit, so manage the trade closely in the last week of expiration!
Here are the Greeks, one day before expiration, with the SPY simulated at the short strikes, ie right in the mouth of the Butterfly.
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Delta
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Gamma
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Vega
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Theta
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0.03
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-24.49
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-$2.61
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$78.16
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Notice the huge increase in Gamma, but an even bigger increase in Theta. I purposely didn’t include any risk graphs in this article, so you can learn to think in ‘Greek’ without being aided by the picture!
Manage your Greeks!
Matt Baker
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