We humans crave both familiarity and new experiences. Some of us want more familiarity, and some want more new experiences.

When trading, there's something to be said for familiarity.

Hypothetical Hedged Butterfly Trade:

Because of scheduling conflicts, I did not enter a JAN monthly trade. If I had, familiarity with the trade would have allowed me to quickly choose the time frame and composition of a trade, as typified by this hypothetical setup.

With the benefit of hindsight, we know now that I likely would have been glad for that upside hedging since the RUT took off to the upside. I would have adjusted this butterfly by now by rolling at least some of the butterflies higher while being glad that the upside hedge kept that profit-and-loss (PnL) line relatively flat. However, when the trade was first contemplated, I wouldn't have known for sure what was going to happen next. Let's look at what I might have been considering, given my familiarity with the trade.

Familiarity with the butterfly trade tells me that the profit-and-loss (PnL) line tends to drop when implied volatilities rise. Those who know about the Greeks of option trading will recognize that this is a negative-vega trade, like an iron condor. Negative vega theoretically measures -272.94. Because the absolute value of the vega is greater than the magnitude of any of other Greeks seen in the pulldown tab, a change in implied volatilities is likely to have the biggest immediate impact on the trade. In other words, until a price move grows outsized, changes in implied volatilities of the option will clearly impact this trade more than price changes over the first few days or weeks of the trade.

If this trade is going to be hurt by rising implied volatilities, why would I make the hurt worse by setting it up so that it's positive delta? I'll explain this comment for newbies to complex trades. Implied volatilities usually rise when price is dropping. Lots of traders of iron condors and butterflies, typical complex negative vega trades, set up their trades so that the delta is negative. This way, a price drop would help the profit-and-loss line, at least a little, and undo some of harm due to the rising implied volatilities often seen during a price drop. Therefore, logic would tell me that my trade's PnL, as the trade is constructed above, is going to be hurt two ways if prices should drop because of the positive deltas and the negative vegas.

However, logic doesn't always hold up to the test of experience and familiarity with the trade. The trade--as illustrated on OptionNET Explorer or Think-or-Swim, from which my live feed comes on OptionNET Explorer--tends to act as if it's far more negative delta than is shown on these two graphing systems. At least, it does this far from expiration. While with other types of negative vega trades, I might want to keep my deltas slightly negative, a few positive deltas is fine with this trade this far out from expiration and is preferable to too negative a delta setup.

That changes as the trade approaches expiration. How would I know all this except through familiarity with the trade, trading it month after month? I might listen to someone else explaining it, but I wouldn't have the same feel for the trade.

If I were using OptionVue or another trade-graphing program, I might be seeing slightly different values for the Greeks and/or the expiration breakevens. The trader using different tools would almost definitely be accustomed to seeing different values even if employing the same setup. Only a trader's familiarity with the trade and the tools used would enable that trader to test various setups and then replicate the ones that tend to work best over time.

What if traders hear about a great YHOO earnings play just before YHOO's January earnings report? Traders can always familiarize themselves with YHOO's behavior before and after earnings reports over the previous year. Many brokerages provide icons that note the date of earnings reports right on the price graph.

Year-to-date Graph of YHOO with Icons Marking Quarterly Reports, Think-or-Swim Graph:

Studying this chart allows traders to familiarize themselves with YHOO's typical behavior leading into and after an earnings announcement, but how do the implied volatilities of the options behave? For most equities, implied volatilities rise ahead of earnings reports and then collapse after their earnings reports unless the reaction is a swift downturn in prices. But how soon ahead of an earnings announcement do implied volatilities begin turning higher in YHOO options? Obviously the price behavior has changed since August. Does a person unfamiliar with YHOO's behavior and prospects have as good an understanding of what might be driving the sharp rise in prices as someone who just scans a list of reporting companies and chooses YHOO? The person familiar with YHOO might be able to better assess whether expectations are so high that there's more likely to be a sell-the-news effect after earnings or further gains when expectations are met. If most earnings plays are predicated on the expectation that implied volatilities will drop after the earnings report, how would such a trade fare if YHOO drops sharply after its report and implied volatilities rise instead?

Traders must consider their familiarity with both the strategy and the underlying before deciding whether and how much money they'll commit to a trade. Those traders who focus best when they have many trades going and are engaged by the emotion of exploring many trades of course will want to try new trades. However, I would suggest that the funds committed to such trades should be small until they familiarize themselves with both the strategy and the behavior of the underlying.

Me? I figure that the markets, dark pools, and high-frequency trading firms deliver enough drama to engage my interests and send the adrenaline levels higher. While I occasionally test a new trade with tiny investments of funds, I value familiarity over variety.

Linda Piazza