It goes without saying that, before we enter an options trade, we should make some key decisions. How will we know if the trade is going wrong? Will the amount of the unrealized loss tell us? Will the violation of a certain price point reveal that information? We should also know what we'll do if the trade does go wrong. That means that we had better know which adjustments we're planning on making, if any.

Early in my options-trading career, when I was ready to move from straight buying of calls or puts, I read a hot-off-the-presses book on complex options strategies. I appreciated the no-nonsense discussion of each strategy and especially the reference material at the back of the book. A one-page spread detailed 19 different strategies, showing the shape of their expiration profit-loss charts, the options positions needed to create them, the market outlook of the position, and the profit and risk potentials. The book also outlined whether each position benefited from time decay or was hurt by it.

By the end of that book, I knew how to calculate expiration breakevens. What I didn't realize at the time, however, was that I might have learned how to construct each of these positions, but I didn't learn a whole lot about how to adjust them. And in not "a whole lot," I mean "nothing." Calculating expiration breakevens wasn't going to do me a lot of good if the position went wrong long before expiration. It's hard to go back to that time when I didn't know a lot about adjustments and remember exactly what I was thinking. However, I think I was left with the impression that the strategies either worked or they didn't. Furthermore, I formed the conclusion, whether justified or not, that whether the strategies resulted in profits or not depended on whether you'd done enough research to pick the right vehicle and time for that particular strategy. If you were right, and there were after all "three ways to be right" with most of the trades, you'd rake in the profits. If you weren't right--And how could you be stupid enough to be wrong?--you'd be punished. You were going to incur the maximum loss or at least a maximum loss you were willing to take before cutting the trade free. But, come on, how often was that going to happen?

That was a dangerous conclusion, in my opinion. It led me to believe that, if I was a good enough trader and technical analyst, my work was done when I had put on the trade. I just monitored it for profits or for losses, or just let those profits or losses build until it was time to take off the trade or let it expire since all that book talked about was the expiration graph. The approach implied some judgment against myself if a trade didn't succeed all by its lonesome once I'd put it on. If a trade or even a number of trades failed, that must mean I was a terrible trader, right, since each trade had so many ways it could succeed? That kind of conclusion sets traders up for some tough struggles, emotionally, financially, or both. Perhaps that conclusion was my fault, but I think the lack of discussion of any adjustments also produced this faulty thinking.

With some trades, such a no-touch approach might be appropriate, but it's certainly not for others. Let's look at a butterfly, for example. For newbies not used to butterflies, a butterfly can be an all call, all put or mixed-put-and-call butterfly. The body is formed by selling options in a multiple of two. The wings are long options in half the size of the body, with each wing typically equidistant from the body. As this article was first roughed out on December 30, it was only 23 days until JAN option expiration, so it was a little late in the cycle to establish a butterfly, but the information I'm going to discuss is true nevertheless.

The problem is that, even when established further away from expiration, it's difficult to construct a butterfly with expiration breakevens wider than one standard deviation for the time until expiration. The chart below shows a RUT butterfly with 50-point wings, for example, with the green lines indicating one and two standard deviations.

RUT Butterfly:

Although not shown on this graph, this butterfly has a probability of profit at expiration of about 60.5 percent. What does this information about probability of profit and standard deviations mean to the trader? The expiration breakevens are narrower than the normal amount of movement you'd expect for the RUT during this period of time. This fact renders it more likely that the RUT is going to violate those expiration breakevens and move out toward at least the first standard deviation levels sometime before that position expires. Such a movement will be typical noise for the RUT, or really for any underlying for which a butterfly might be constructed. Depending on when that move occurs, the loss incurred while the RUT is just engaging in normal movements over that time period could be quite severe. For example, the upside breakeven is at about 816.10 on this particular butterfly with the upside one-standard deviation move to the upside being anything below about 842.25 or so (eyeballed and not calculated). What if, by January 13, the RUT has moved to 829, a typical one-standard deviation move for this shorter time period? I haven't shown the "today" theoretical profit/loss chart for January, but the software used above, OptionsOracle, calculates a theoretical loss of 43 percent of the margin requirement for the position.

This brings us back to the original discussion, about the conclusion I reached the first time I learned the parameters of all these complex options strategies. Books or articles that fail to discuss adjustments cheat traders. More than likely, you're going to have to adjust a butterfly, or you may be faced with closing more of those for a loss than you want to do. If the choice is made to handle these as a no-touch sort of trade, with the trade closed whenever a maximum acceptable-to-you loss is reached, backtesting becomes even more important. You know from the outset that those expiration breakevens may be exceeded during the course of the trade, just due to normal noise. Depending on the vehicle and the time in the cycle when the expiration breakeven is exceeded, that may mean that overall, there's a fairly high percentage chance that a butterfly trade will have to be closed for a loss if it's not adjusted. If so, you'd better know, as much as it's possible to know, how you're going to adjust before you ever enter that trade.

The way you adjust can include adding extra long calls or puts as necessary, adding a new butterfly at the expiration breakeven if it's reached, moving the butterfly, or even moving in the wings, among others. Each choice will impact the trade and the margin requirements differently. When the trade is initiated, it's important that the trader have a preferred method of adjustment in mind and leave plenty of money in the account to make that adjustment. For example, if the adjustment is going to be adding another butterfly at some point, that butterfly may have a higher or lower margin requirement than the original one, depending on volatility and other inputs into options pricing. Margin requirements may more than double, then. If another butterfly is added, such an action may result in buying back some of your previous shorts and/or selling some of your previous longs if the strikes overlap. Your brokerage may interpret this as an unbalanced position so that margin is held on two sides. In a butterfly trade, margin requirements can easily spiral well above the original requirements. Traders who leave inadequate cash in their accounts will be unable to adjust as freely as other traders. Traders who have locked themselves into butterfly trades that they can't adjust due to margin requirements have no choice but to exit a trade that has reached an adjustment point or the maximum appropriate loss for the trader.

I no longer think that when a trade needs an adjustment, I've failed. Such beliefs can lead some traders to hold onto losing trades because they can't deal with the sense of failure. When a trade such as a butterfly is often going to need adjustment due to the nature of the trade, how can it be a personal failure that one might need adjusting? I do my best to find the right time and the right vehicle, but that's the best I can do. While I know better than to put a butterfly on in a high-beta underlying that I expect to run all over the place before option expiration, I am not in control of all market behavior.

I do worry about new traders learning about these complex strategies from sources that don't urge them to back test adjustments, too, to learn which types best fit their personalities, the size of their accounts, and their access to their trading screens during the market day. The most experienced options traders go further than thinking about how much money they'll need for adjustments when a trade is going wrong, too. They think about whether the best hedge against adverse price action is an extra long call or put in the current month's options or out a month. They think about how time will erode the protective quality of those extra long options or even the long options that are part of the initial strategy, such as the outside long options, the wings, on one of those butterflies. They think about whether one adjustment might be easier to put or take off during fast market conditions. (Hint: It's almost always easier to hedge with long options during fast market conditions than it is to fiddle around with a spread order.) These days, I'm always looking for adjustments that take off risk rather than add more risk, so I might lower the price-related risk by taking off some of the spreads that are part of my initial position. But most of all, experienced options traders know going into a trade, as much as is possible, whether they will adjust if needed, how they will adjust if needed, and how much money that adjustment is likely to require.