As I've mentioned in many recent articles, I trade a complex butterfly position that's hedged against risk to the upside and the downside. Where's the risk in this trade?

My October Trade the Day of Entry, 64 Days to Expiration:

This expiration graph is produced by OptionNet Explorer, but many online brokerages will provide at least a rough approximation of this graph, too. For those unused to looking at expiration graphs, this shows the typical tent-shaped expiration graph for a butterfly trade, with the profit or loss at expiration graphed against various price points.

For example, eyeballing the graph shows us that if the RUT were to be near 1120 at October's expiration, the trader who had initiated and held onto that trade would have raked in a little over $40,000. Not many traders I know hold European-settled index options into expiration, however, as their Friday-morning settlement values can be far off their Thursday close for the underlying index. Also, these trades get harder to wrangle as expiration approaches. Most traders of these type of hedged trades have a planned profit target and a planned stop loss level at which they'll exit the trade. That planned stop loss level is one way of thinking about your risk in the trade.

I would argue that the trader go further, however. Another way of thinking about risk is by looking at the maximum that could be lost if you were to be offered a three-month trip to a far-off island and jet away, forgetting about your trade and letting it run. For the trade pictured above on day of entry, that's a little over $21,500. That maximum loss would only be hit if the RUT were to be below about 1070 but above about 1020 at expiration. A little below 1020 (1020 - the cost of buying the put), the extra 1020 put would be in the money at expiration and would ameliorate the loss at expiration. You could decide where you intend to stop your losses and get out of a trade, but this maximum possible loss is one I consider my true risk if all goes wrong.

If the RUT's price were above the upside breakeven at expiration, the maximum loss would less, around $10,000 as seen by eyeballing the graph. That's because the extra deep-in-the-money long call and the 1120/1140 call debit spread would ameliorate any loss to the upside.

Identifying the most that can be lost if the trader were to jet off and forget a trade is one way of looking at risk. Clearly and intuitively then, price risk is the risk most of us think about when we think about the risk in a trade.

Is it enough to think about the risk in a trade due to the movement of the underlying? What's going to cause that trade the most trouble in the near future or in the amount of time we plan to stay in the trade? The flattish blue and red "today" line gives us some of that information, although the Greeks of the trade give us more.

The flat today line tells us that there's not much risk immediately from a price change alone if nothing else changes. The RUT can range pretty far in price to either side of the then-current value without suffering much of a loss as long as nothing else changes. For those who know about the Greeks of the trade or are interested, the delta value tells us this, too. It's a flattish -6.10. Theoretically, as long as other conditions don't change, the trade loses about $6.10 for every point the RUT gains and benefits by about the same amount for every point the RUT loses.

I added a couple of "if nothing else changes" caveats to that previous paragraph. That's because the biggest immediate risk to this trade perhaps isn't from price action. It's from a change in implied volatilities. As a recent article also discussed, Vega tells us how to estimate the gain or loss from a change in implied volatilities. Iron condors and butterflies are negative vega trades. That means that they'll be hurt by a rise in implied volatilities. This trade has a vega of -306.15 at inception. At my trade's inception, that Vega number is obviously so much bigger in absolute value than any of the other numbers from the pulldown tab listing the Greeks that it's going to have more impact on the profit or loss than other factors.

Conclusion? The biggest immediate impact on the trade will come from a change in implied volatilities. That's what you have to be aware of when you're trading iron condors and butterflies. Some options traders wait until there's an expansion in implied volatilities to place these trades if they believe that implied volatilities are about ready to contract again. In the case of an iron condor, for example, a trader would get a better premium for opening (by selling the iron condor) this trade if volatility had expanded. Traders then will see profit build if the implied volatilities sink if a relief rally doesn't grow so large that the price action causes problem. Traders should also be cautious about entering such trades if markets still appear vulnerable to a sharp downdraft. High implied volatilities can quickly escalate if key support is lost, for example.

Risk can be assessed in at least two ways, then: the ultimate maximum that could be lost if the trade is ignored and the factor that would cause the most immediate harm to the trade.

The factor that would cause the most immediate harm might change as the trade progresses. I have copied my original live trade and carried it forward with a different adjustment practice than I actually employed. I thought this graph useful to illustrate the way those immediate risks can change. This is that carried-forward (now hypothetical) trade just five days after it was initiated.

Theoretical Changes Five Days after Opening the Trade:

The today line is still relatively flat, due to the addition of two more 1120/1140 call debit spreads. Even with the addition of those additional call debit spreads, the volatility-related risk has lowered a lot, perhaps more than would ordinarily be expected in a five-day period so long before option expiration. Why? During those five days, price had rallied sharply with implied volatilities dropping sharply. A sharp rise in implied volatilities remained a big risk to this trade's performance, but it wasn't as big a risk as it had been.

Twelve Days into the Trade:

Remember that this trade is no longer set up exactly as my live trade was, because I had made more adjustments by this period. However, I wanted to show how the risks would have changed without those particular adjustments. Twelve days later, a sharp rally and the passage of time had combined to reduce vega even more.

Volatility risks change over time with this trade.

If this had been another trade, we might have observed that risks arrayed themselves differently. For example, if a trader liked pure directional swing trades of a few days' duration and had bought a deep-in-the-money long call, risks would array themselves differently. Theta--the Greek that measures the impact of the passage of time--would have been negative. Depending on the strike of the call and the time before expiration, that theta-related risk could have been considerable when the trade was initiated. Fortunately for our theoretical call-buyer who bought a long call 64 days before October's expiration, the RUT rose sharply enough that the delta-related gains likely overcame any losses due the decay caused by the passage of time. For example, the long 1020 call that was originally part of the trade was bought at $125.30 and was $142.75 on the 19th. (Note: Observant readers will notice that I had rolled that 1020 call to the 1050 call by the 19th, locking in part of the profit when the RUT rose so quickly.)

The lesson learned is that different trades will have different risks and those risks might change over time. Looking at the today profit-and-loss line will tell us some things about immediate risk, even for those who don't want to know about the Greeks. Studying the expiration graph will tell us how that today line is eventually going to drape itself: expect the today line to look more and more like the expiration graph as time grows closer to expiration.

Here's another neat trick to remember, though: a drop in implied volatilities changes the draping so that it looks more like the expiration line, and a rise in implied volatility changes the draping so that the today line looks more like it did further away from expiration. How much further away? That depends on how much the implied volatilities change.

Several types of risk have been mentioned in this article: the price risk implied by an intended stop loss level at which the trade would be exited, the maximum loss that could be endured if the unthinkable happened, and risks due to changes in implied volatilities or the passage of time. "Time" relates to another way we must assess risk. When we think about time-related risk, that risk doesn't relate only to option decay.

It's all well and good to look at our well-balanced trades and think we understand risk, but what about the risk of events that could occur over time? Obviously a trade initiated more than two months before expiration is going to have more event risk than one initiated two weeks before expiration. As a recent article pointed out, November trades will not expire until after the midterm elections. Those traders planning to hold November trades open until close to expiration will face that risk of turmoil in the markets leading up to and immediately following those elections. Whether any problems occur, I obviously can't predict.

Risk can come from several factors. We option traders might have another risk to add soon: the risk of sharp changes in interest rates. There's also the risk of missing out on a profitable trade when we insist on hanging onto a losing one beyond our planned exit level because the underlying "has got to turn around." It's important that we think about what we risk when we trade options. The purpose isn't to scare ourselves but to plan for how we'll deal with that risk.

Linda Piazza