When I began a series of articles about stops, I mentioned that the topic was complicated. The first few articles dealt with directional trades. One key to placing the initial stop was established in the first article about directional trades. Traders should ask themselves, "What was I thinking when I entered the trade?" Was the trade prompted by a particular chart formation, bounce from a trendline or decline below a particular moving average? Knowing what prompted the trade makes it easier to set the initial stop, as previous articles established. Those articles can be reviewed for more precise information.
However, once a trade has garnered significant profit, the trader seldom wants to let the underlying's price retrace all the way to the initial stop. Subsequent stops can trail a rising trendline, a declining moving average or the option's price. Since an option's price also depends on volatility and the passage of time, among other inputs, the trader must have a maximum loss in mind when the trade is initiated. It's entirely possible to have the underlying's price action going just the right direction, but travel that direction so slowly that time decay undercuts the price of the option faster than the price action benefits it. It's the cost of the option that delivers our profits or losses, not the price of the underlying, so directional options traders must also keep their eyes on the price of the option they hold or have sold. The question that prompted this series of article referenced whether stops should be based on the action of the underlying or the price of the option. As with many aspects of trading options, we trade the wonderful flexibility of options for increased complexity in answering such questions. Both must be considered, it turns out.
That's also true for those who have entered complex options positions. If determining where to set a stop proves difficult for directional trades, it may be even more so for complex, non-directional trades. Such trades benefit when the underlying doesn't move much, but losses or profits often depend as much on volatility and time passage as they do price action. For example, when a high probability iron condor is first established, the trade has a relatively flat delta, the Greek that measures how much the trade losses or benefits from the price action of the underlying. However, it will have a relatively enormous negative vega, which means that, at least initially, it's going to be helped or hurt far more by a change in volatility than it will be by a change in the underlying's price, within certain parameters. As I type, the SPX is less than two points below the level at which I established a 25-contract iron condor the previous day. Yet my position is theoretically down 5.39 percent of the margin, due almost entirely to a rise in volatility that has widened the spreads that I sold the previous day. I sold them for a certain price, and now, due to the increased volatility, they're worth quite a bit more than that price.
In no other type of option trade is it more important for traders to know what they're thinking than in the process of setting stops for these complex positions. What was the original profit target and what was the planned-for maximum loss? What type of adjustments does the trader plan to contain both price and volatility risks, and can they be instituted before a maximum loss is reached? The trader of more complex options strategies soon discovers that the price of the underlying may or may not be a primary force in how the trade behaves. That trader must first of all keep an eye on those underlying theoretical profits and losses.
For example, let's look at the case of an IBM SEP call butterfly priced on the afternoon of August 5, 2010, when IBM was priced at 131.88. I've used mid prices for these charts, although I know that we often don't get mid prices on our options trades. Getting close to mid prices is much easier on IBM than on some other instruments, however, and this theoretical pricing allows us to examine the points necessary to make.
Profit/Loss Graph for IBM SEP Call Butterfly with 10-Point Wide Wings:
Strategy Summary for IBM SEP Call Butterfly:
Note: The buying-power effect of this trade would be the debit spent to enter it, $461.50. This is the buying-power effect or margin withheld at most brokerages.
As the strategy graph shows and the strategy summary numerates, the maximum profit potential for this positions--without commissions, which haven't been included--would occur if IBM ended September's expiration cycle at $130, with that potential profit at $538.50. The maximum loss would be $461.50 (plus commissions), the debit spent to enter the position. According to this source, this maximum loss would be incurred if IBM were to end the expiration cycle below $124.62 or above $135.38.
A trader would have to hold that position until expiration in order to collect that maximum gain, however. When the trader enters the trade, that trader has to have some idea, based on experience or back testing, of the maximum gain to be realistically expected about a week before expiration. For example, let's take a look at the potential profit if IBM were to sit right at that same price straight through until September 10, the Friday before expiration week. Let's look at what the potential profit is on that day, if price and volatility stay the same.
Theoretical Profit/Loss on September 10:
The theoretical profit for this position at this time, barring any change in volatility, would be about $254.61 or 55.17 percent of the buying-power effect of this trade. If IBM had moved to 130 and was sitting there, the theoretical profit potential would be even higher, minus commissions.
Of course, it doesn't work out that nicely very often. Wherever price may have moved and whatever adjustment have been needed in the interim, many butterfly traders like to close them by the Friday before expiration. To use a tongue-in-cheek "technical" term, wonky things can happen to any trade during expiration week and even the week before expiration. This is especially true of complex trades such as butterflies, iron condors and calendars.
Although I know butterfly traders who aim higher, it seems likely that the butterfly trader would expect a maximum profit of about 15-20 percent, depending on how conservative or aggressive that trade might be. So, if 15-20 percent is the maximum the trader is realistically going to make, how much should that trader be willing to lose? Let's say this particular butterfly trader is an expert at reeling in a 20 percent profit most of the time. Trading records show this strategy is profitable three out of four cycles for this hypothetical expert trader. Perhaps that trader is willing to risk a loss about 5 percent higher than the typical profitable trade. Another trader with a 50/50 profit/loss record might want to keep the loss a bit smaller than the typical gain.
Once the trader of this complex position has determined the maximum loss, a stop can be set at that maximum loss. For example, on September 10, the Friday before expiration week for this strategy, a 20 percent loss will be incurred if IBM has climbed to about $139, if volatility stays the same. In actuality, volatility will probably have dropped if there's a steady climb to $139, and that drop in volatility will make the downward slope of the profit/loss chart less steep.
The point at which the intended profit target and maximum loss will be found will therefore differ from day to day, depending on how much time has passed, the changes in volatility and the price action of the underlying. The trader must be attentive, changing stops as appropriate.
However, as befits the term "complex strategy," there's more to be considered. A trader of a complex strategy such as a butterfly, iron condor or calendar doesn't have to sit passively and wait for the maximum loss to be incurred on a strategy such as this. Many adjustment strategies are possible. Some butterfly traders add an extra long call or put as the upside or downside breakeven is approached and that "today" curve starts to dive into steeper losses. This action smoothes out the delta of the overall position. Some butterfly traders adjust by moving one of the spreads out when price action approaches the expiration breakeven. Some might lift up the in-trouble butterfly, selling it and buying another centered at the new at-the-money price. Others might adjust by adding another butterfly, adding it at some point as the underlying's price approaches the expiration breakeven.
Many possibilities exist. This isn't meant to discuss all the pros and cons of adjustment methods for butterflies or any of these other strategies. However, I do want to point out that in some of the possible adjustment strategies, the trader has increased the buying-power effect of the trade. If the trader does this and had an original maximum loss set at 20 percent of the buying-power effect of the trade, is that maximum loss now going to be upped to 20 percent of the increased buying-power effect? In other words, is the trader going to be willing to keep adding to the potential loss, or will the trader keep the same original profit target and planned maximum loss?
In other words, we're back to that original premise established when we first began talking about stops. What was the trader's intention when the trade was opened? The experienced butterfly trader knows the butterfly will likely need to be adjusted more frequently than the high-probability iron condor, or, so goes the theory. When the trade is initiated, does the trader plan to add another butterfly at some point and so the planned original maximum loss and stop incorporates that idea?
There's no right or wrong with these decisions about complex trades, the same as with other types of trades. Each decision has its pros and cons. The takeaway for this article is that the trader employing complex strategies might consider deciding on a profit target before entering the trade and then base the appropriate stop on that profit target. The maximum loss should not be too far out of proportion to the planned profit and should take into effect whether this trade has been mostly profitable or only marginally so for the particular trader. The point at which the maximum loss would be hit will often vary from day to day with these strategies due to the passage of time, changes in volatility and the price movement of the underlying. The trader who can't watch the markets every moment should look at profit/loss charts at least once a day. Resetting appropriate stops frequently might be necessary if that trader won't be able to get to a computer and adjust trades. Trades can be adjusted, but the trader might want to consider the cost of possible adjustments at the beginning of the trade, making decisions about whether the maximum percentage loss will be based on the original buying-power effect or the larger anticipated buying-power effect after planned possible adjustments are indeed made.