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I have access to daily vol quotes for EURUSD options from 2006 to today. I was playing around with them and constructed a "daily rolled backtest" for various options constructs, like straddle, 25 delta risk reversal and 25 delta butterfly. This means I am buying, say a 1M straddle today, hold it for one trading day and my pnl would be the difference between today's and tomorrow s price. I am using the full term structure to price the options one day later, so I am considering the vol roll down. When I do this, the pnl series for straddle and risk reversal are fairly well behaved but for butterfly I get some crazy sharpes of about -5 or less for the 1M and 2M tenors. Shorting the butterfly gives me almost a straight line up in the backtest, which looks very weird. This would mean that FX convexity is heavily overpriced. If I compare this to S&P for example, things look very different. Shorting the butterflies performs rather poorly there. I am aware that this strategy I am looking at here is not tradable since the transaction costs of daily rolling are prohibitive, but can this be true? If I can find a more realistic way of rolling, I could probably still get a very profitable strategy? If convexity in EURUSD is really so heavily overpriced compared to other underlying, what is the reason?

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    $\begingroup$ How exactly did you do this with what data? If you use daily rolls, you will need to either manually compute the 1m-1d vol via interpolation, or you use some vendor computed value. Butterflies are the main building block (with ATM DNS and RR) for FX vol surface costruction. Insofar, if you could easily get a (very) profitable strategy, I would say it would imply that all market makers are consistently giving away free lunches. $\endgroup$
    – AKdemy
    Commented Aug 11, 2021 at 22:38
  • $\begingroup$ If I only look at 1M tenor, I need data for the volsurface of 1M and the next tenor shorter than that, I.e. 3W. Then I can interpolate the "1M minus 1 trading day" vol surface which is used to price yesterday's 1M options on today's market. $\endgroup$
    – Volwiz
    Commented Aug 12, 2021 at 9:10
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    $\begingroup$ There was a sellside piece earlier in the year on trading FX vol. In it, they looked at trading long strangles vs straddles but gamma-weighted (so not really a 'true' fly). Their conclusion was, "This strategy performs well before transaction costs, confirming the existence of a structural vol of vol premium. Unfortunately it does not survive transaction costs". I.e. flies should be fairly priced, not a free lunch/Sharpe of 5. $\endgroup$
    – user42108
    Commented Aug 13, 2021 at 21:19
  • $\begingroup$ Thanks. I would be very interested in this piece. I suppose you cannot send it to me, but do you know the name of the bank and maybe the title, so I can check if my institution is subscribed to this? $\endgroup$
    – Volwiz
    Commented Aug 14, 2021 at 22:06
  • $\begingroup$ Hi Ben - SocGen piece titled "Systematic trading in options: Looking for premium in currencies across the globe", Feb 2020. I was mistaken in writing that it was published earlier this year. $\endgroup$
    – user42108
    Commented Aug 16, 2021 at 14:02

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