Imagine that the morning of Monday, April 11, 2012, you were relieved to see futures slightly higher. You're a cowboy or cowgirl trader who likes aggressive short-term trades, and you wanted to take advantage of the higher implied volatilities over the recent days to begin a butterfly.
For those new to trading options, a butterfly can be an all-call, all-put or a combination put and call butterfly. For example, the chart below shows the strikes I chose to establish a sample butterfly that is a combination of puts and calls, an iron butterfly. Also, I used to trade "weeklies" on the OEX, when there were no such things as weeklies and I was just trading the last 10 days to a week of the expiration cycle. I used the XEO options for this purpose, to avoid the minute possibility of assignment before expiration, although that's probably not even a valid worry. I no longer trade these trades. Markets are different than they were back then, much more volatile with bigger gaps in the mornings. Therefore, while I'm using this setup to demonstrate what you can test on a charting program, I'm not in favor of newbie traders trading into option expiration week. In fact, I try to avoid it in my own trades.
Note: I didn't notice that when the first chart was snapped, I had included one OEX call with the rest of the options being the XEO options. I corrected that later, but forgot to resnap this picture.
The position has the typical tent shape for a butterfly:
However, imagine that at the end of the day, you start hearing a lot of negative talk about what's about to happen to the markets, and the talk scares you. You notice that the "today" chart, when reset for the next day, falls off quite steeply, with losses accumulating quickly if the OEX drops, for example, two percent the next day.
The legend under the chart isn't visible, but it predicts a theoretical loss of $1,219 if the OEX were to drop about two percent the next day.
I could talk here about flattening deltas and all that sort of thing, but I'm aware that some traders just want to see a visual and not talk about Greeks. Let's just look at visuals in this article and nix the talk about the Greeks. First, you would have to decide whether you're more worried about one of those rabid rallies getting started or about a gap or that two-percent rapid decline. Let's say for the purposes of this article that it's the possibility of a decline that worries you.
Let's try a couple of ideas and see what they do to the expiration and/or today charts. Let's start out with the knowledge that OptionsOracle calculates the margin, with theoretical $1.25 per option commissions, at $7,492.00 for the original position.
How about adding an extra OTM put? You could spend $135 plus commission to buy a long 600 put. Would that make any difference?
T+1 Chart with Extra Long Put:
Let's look again at where the position would be if the OEX were to drop two percent the next day. The theoretical loss would be $993.97, far less than the original loss. Margin has now increased to $7,631.50, however. I've shown the "T+1" chart and not the expiration chart, but I can tell you that the upside expiration breakeven has now moved lower, to 635.92 from the previous 636.27, so the trade would get into trouble a little quicker on the upside. The Strategy Summary shown below sets out the new breakevens and other factors.
Strategy Notes for Adjusted Trade:
This trade we've been examining is a 4-contract iron butterfly. What would happen if you used a long debit put spread to hedge the downside risk instead of buying a straight long position? Of course, the result would depend on which spread you chose. What if, for example, the put spreads in your iron butterfly consist of 4 sold 625 puts and 4 long 595 puts, as this particular butterfly is constructed? What would happen if you were to buy back one of the sold 625 puts and sell one of the long 595 puts, a somewhat extreme first adjustment for a trade not yet in trouble?
T+1 Chart for New Adjustment:
The potential loss if the OEX were to drop two percent the next day is even smaller than with the first adjustment idea, now at about $446.78. However, the upside expiration breakeven is moved even lower, and the margin in the trade is higher. Maximum profit potential has been reduced, although I don't know many butterfly traders who let their butterflies go right into expiration. Few collect that maximum profit potential, even if they happen to have the underlying's price right at the sweet spot, also a somewhat unlikely event. Therefore, the increased margin might be of more concern than the lowered profit potential.
Strategy Chart for New Adjustment:
These are not suggested adjustments. Most people would not have thought that butterfly needed any adjustments on April 11, and many traders would counsel against letting rumors spook you. However, what I'm doing is showing what you can do with a profit-loss chart even if you could care less about learning about the Greeks of options pricing. These theoretical results are just that: theoretical and not etched in stone. However, they can help you brainstorm.
There's another idea to be considered if you've just entered a trade and something dramatically changes your outlook. Perhaps you learn that your four-year-old will need a tonsillectomy the next day and is likely to be very clingy for the next week, so that you won't have much time to pay attention to a trade.
You can always exit the trade.
This trade could perhaps have been exited for the cost of commissions, although I was not in the trade and did not attempt to enter and exit and so can't be certain. However, if one's outlook has changed and the trade no longer feels as viable, paying a few dollars to get back out and rethink it is not the worst thing that can happen. It should be considered as a possible tactic.