On Thursday, October 11, 2012, I was waiting for my RUT NOV butterfly trade to hopefully ripen to my planned profit so I could harvest it. The trade wasn't there yet, so I was stuck trying to keep from watching it obsessively.

We all have times when we're trying to keep our hands off a trade or have told ourselves it's not a good time to enter a trade. Those times don't have to be wasted.

For example, many trading platforms have some sort of spread book you can watch to see who is trading what. If your platform doesn't, CBOE does. Because my trade was a RUT butterfly, I was interested in what was happening with RUT butterflies. Here's part of what I saw when I called up the spread book. Note that I had to scrunch the columns together to meet size requirements for publication.

RUT Spread Book from Think-or-Swim:

This represents only part of the page I was viewing, but it was a fairly representative part. What did I notice first? Throughout the orders I scanned, I saw a lot more sell orders than I normally see. This was a day when the RUT was bouncing after a few days of declining prices. Implied volatilities were coming down and this negative-vega trade was benefitting. But what happens in any market when there are more sellers than buyers? Buyers have their pick of prices. They don't have to offer higher prices to entice sellers to sell to them.

That told me that I might not be able to depend on a projected profit that was based on the mid prices of my flies. Unless the conditions changed, I likely wasn't going to collect the mid. My profit was probably going to be less than the theoretical profit I was being shown. Useful information.

Of course, these spread books can change moment by moment, as they certainly did that day. I would be watching the trend, as I tend to do in the days preceding my entry or exit of a complex trade.

Did you notice that someone was trying to buy a +5 OCT 780 C/-10 790 OCT call/+5 OCT 800 call for a $0.23 debit? At the time, the mid price was $0.20. The RUT was hovering around 835 at the time. What's that about, a butterfly with 10-point wings, way below the action? As far as I'm concerned, the purpose of "down" time in the markets when I'm nevertheless stuck at the computer, is to either practice my violin or to learn more about trading. Talking about the violin techniques I'm practicing right now won't help, but perhaps we can learn something from examining what that would-be butterfly trader might be thinking.

RUT Below-the-Money Butterfly:

A little explanation might be in order for those not familiar with think-or-swim's "Analyze" or profit-or-loss page. The red line shows the profit or loss at expiration at various price points. The white line shows the theoretical profit or loss at various price points for the day being viewed. The red vertical lines mark that day's breakeven as well as the two expiration breakeven points.

What can we tell from scanning the chart? The maximum loss is small. In fact, it amounts to what is paid for the five butterflies plus commissions: $0.23 x 5 x 100 multiplier = $115 plus commissions. Clearly, the trader who wants to enter this trade is making a cheap bet.

And what is that trader betting? That trade benefits on that day if the RUT pulls back. It would have benefitted big if the RUT is in the "sweet spot" at expiration, at 790. The trader could theoretically make big money if the RUT had settled at 790.

That trader theoretically could make a big return at expiration if the RUT were in a narrow price range far below the money at entry. However, even if the RUT rolled over on that day I was watching the spreads and pulled back to the previous day's close, the trader could theoretically make back all the investment. So, is it a cheap bet on a one-day move? Hmm. I don't know, but I think that's unlikely. There would have been easier and less commission-intensive ways to make money on a rollover.

It looks like either a speculative bet or a hedge against another trade. On CBOE webinars, former market maker Dan Sheridan calls such trades "time bomb" butterflies. If price goes to the butterfly's central strike at expiration, the potential value explodes higher.

I know people who trade these in very small size in the speculative portion of their portfolios. I also know people who use them to hedge their other positions. My own history with these doesn't lend me to use them as a speculative tool unless I just want to give away my money. I've had the price come right into the sweet spot a day before option expiration and stay there for a couple of hours and still not be able to collect anywhere near the profit the theoretical charts suggested I would. I hear from other traders, too, that you pretty well have to wait until expiration to collect that profit

Waiting until expiration presents its own difficulties, particularly if you're employing one of the ETF's such as SPY to trade these, and if you're employing calls to set up the trade. SPY and some other ETFs offer dividends. They go often go ex-dividend in expiration week, and that means you do not want to have sold a call that's in the money and stay in that call during expiration week, when the SPY call in question will have very little extrinsic (time) value left and might well get called. What happens then? You wake up one morning without the central calls to your butterfly, short some SPY shares, and, to rub salt in the wound, you owe someone dividends.

Obviously, the ex-dividend issue does not arise with the RUT since it offers no dividends and has European settlement. Those sold calls are not a problem in the same way. However, I would caution traders against setting up a far-below-the-money call butterfly in any stock or other entity that does not feature European settlement.

I have another question about why calls for this trade. Let's look at the bid/ask spread for an OCT at-the-money call that morning.

Bid/ask spread for OCT 835 call when RUT @ 833.67:

Notice that there's a $0.40 spread between the bid and the ask. What about for the central strike of that time-bomb butterfly, the 790?

Bid/ask spread for the OCT 790 call when RUT @ 833.60:

The bid/ask spread for the 790 is $0.90, and, for the 780 that's part of that butterfly, it's $1.60. With wider bid/ask spreads, there's more room for slippage in the trade. Of course, if you can get into a 5-contract butterfly for $0.23/contract, you're not too worried about the slippage, but this can be a factor if you thought the RUT was in imminent danger of rolling over and you planned to sell it a few minutes later and collect a 50 percent profit on your trade. That theoretical profit might be lost in commissions and slippage.

So, in truth, I'm not sure why someone would employ calls in this situation, although there's likely a reason I don't understand. Perhaps if it's intended as a hedge, and the price will come to the money, there would be a benefit in being in calls over puts, because the implied volatilities of puts inflates differently in a decline than happens for the calls. I don't trade these enough to be certain, but I've certainly traded them enough to have been caught on a SPY ex-dividend day that I didn't see coming. The risk is not always limited to what you paid for the trade.

There you go. This scan kept me from obsessing over a trade one day last week--and risking overtrading it. Your "down time" or "sit on hands" time doesn't have to be unproductive, either. If you're stuck at the computer and you're deepening your knowledge of trading, you're "not doing nothing."

A note before I go. Friday's action was tough for many trades, and it's my sincere wish that our readers weren't hurt. I'm sure you've heard all the dire prediction and the comparisons to the 1987 crash. We've talked a lot about hedging and managing risks on this page, and I hope you've done some of that when put options were cheap to purchase. I don't know what will happen next, but I do know that volatility has returned to the markets. It's a time for inexperienced traders to retreat to paper trading or trading in small lots for the real-life experience without too much opportunity to be hurt. It's time for experienced traders to examine their risks and ask tough questions about what they can afford to risk.

And it's time to take a deep breath. When I look at the charts for the major indices, what I see is indices that have pulled back within a flag shape at the top of a climb. We don't yet know whether the indices are going to bounce right back up through those flag shapes to test resistance again or if they're going to finally fall through the support and tumble lower. Plan your trades. Manage your risk.