A group of several traders invited me to participate in their end-of-the-day review of a particular trade. I was happy and excited to do so. I gave my opinion of the pros and cons of several adjustments that were discussed. However, I was also somewhat reluctant to vote when the group asked everyone to vote on the action that might be taken.

That wasn't false humility. The underlying for that trade was an equity that I had never traded. I don't know a thing about it. Let's review the reasons for my reluctance. Doing so might help us review what we all need to know about an underlying before committing any money, or at least much money, to a trade on that underlying.

It wasn't the strategy that led to my reluctance. The strategy in this case happened to be a much-adjusted iron butterfly. For newby option traders, an iron butterfly is formed by selling at- or at least near-the-money puts and calls, forming the body of the butterfly, and buying an equal number of puts and calls equidistant from the body. For example, with the OEX at 518.09 as I type, I could sell one FEB 580 call and one FEB 580 put, then hedge that short straddle with one FEB 610 call and one FEB 550 put, forming an iron butterfly. This isn't a trade suggestion, but rather an explanation of the strategy for the newby trader. Since the OEX is between two strikes, I could also split the strikes, and sell one FEB 585 call and buy one FEB 615 one instead of the original version. It would still qualify as an iron butterfly in most traders' eyes. It's really a scrunched-together iron condor, taking in credit, but it looks like and behaves like a traditional all-call or all-put butterfly.

I like iron butterflies, a strategy that has both similarities and dissimilarities with the high-probability iron condors that I most often trade. I've traded a number of iron butterflies through the year, and I adjust them much as this group of traders had adjusted theirs. That wasn't the problem, the reason for my reluctance to vote.

This group was a group or traders who followed the "trading by the Greeks" philosophy sometimes explained by former market maker Dan Sheridan on free CBOE webinars. They tended to look at the Greeks of the position in their end-of-the-day review. I wouldn't consider myself an expert on trading by the Greeks, but I also look at the Greeks of a trade at the end of the day. I've been trading the high-prob iron condors for so long, for example, that I know that a 25-lot of these trades on the SPX is likely in trouble if the absolute value of the delta is above 80. The trade probably needs adjustment and may even be past an optimum adjustment level, depending on how the trade is adjusted.

For newbies, delta measures how much the trade will be helped or will suffer if price moves one point. An SPX 25-contract iron condor with a delta of -80, for example, will theoretically gain $80 for each point that the SPX declines and will lose $80 for each point the SPX rises. Of course, there's a little more to this business of delta than that, but this gives at least some idea of how the trade will react to a change in price. A delta with an absolute value of 80 means that the trade is probably already losing money, in my experience, so the possibility of an additional $80/SPX point additional loss can mean a gap up the next morning will leave the trade hurting badly. For example, within the first five minutes of opening on January 3, the SPX had zoomed up almost 11 points higher than the previous week's close. Likely, the volatilities were plumped up, widening spreads, too. Anyone with an SPX trade that was on the cusp of needing an adjustment as the previous week closed was probably way past the maximum loss that trader expected to ever take on that January morning, especially if the trade had a delta of -80 or so. Moreover, SPX trades likely weren't filling well until the markets settled down later in the day.

Therefore, it wasn't the idea of trading by the Greeks that made me reluctant to offer a strong opinion, either. While I don't trade solely by the Greeks, I certainly look at them all the time and have for years, helping me to make trading decisions.

What bothered me was that I knew nothing about the underlying. I knew that the SPX could gap up or down early in the morning, at least in the last couple of years. Back in the mid 2000's, I would have told you the SPX was unlikely to gap in the mornings. Did this underlying gap frequently? When I'm trading an equity, I want to know whether there are a lot of shorts in that underlying. If there are, and there's a gap up in the morning, then massive short covering is likely going to follow. As it turned out, more research on my part later showed that the short float was a hefty 20+ percent of the total float of the stock, certainly making me suspect that a short squeeze could be possible.

Is there enough liquidity in the stock and options to get out or to buy hedging longs if the stock is subject to a big move and one occurred? If there was enough liquidity recently, did that mean there always was, or would momentum players bail quickly in fast-market conditions? That short float could mean trouble, for example, if would-be put sellers couldn't borrow the stock to short in order to balance their deltas, something that could certainly happen if the days needed to cover that hefty short float was too long. That means that it might be quite expensive to buy puts from would-be sellers. It can be difficult to trade a spread in fast market conditions, no matter which direction the move, if there's not enough liquidity. I got caught once sometime in 2005 or 2006 in a gap and strong early morning run up in CME at a time when it was too thinly traded to allow me an easy exit. That's not an experience I want to repeat, and I certainly don't want anyone else to experience it, either.

How far away are earnings for this stock? Is an ex-dividend day near? I love technical analysis. I do use it in my income trades to tell me that there's a risk of running up or down to certain points, so I can hedge, if necessary. However, even those who use technical analysis sure better know the answers to these questions before they trade a new underlying.

This group also used a risk-analysis or profit-loss chart to study their position. That didn't bother me, either, and wasn't the reason for my hesitation. I do that, too. However, I'm familiar with how my typical vehicles behave on such a chart. For example, when I'm trading any strategy that employs out-of-the-money options on the SPX, I know that all it takes is for someone to put in a funky order on one of those out-of-the-money options I hold, and the mark or mid price of those options is going to change. Since most traders use the mark or mid price in their risk-analysis or profit-loss charts, such an unfilled order is going to distort my theoretical profit or loss and give me some crazy-making numbers. Especially soon after the trade is entered, before much time-related decay has occurred, such an order can swing my theoretical profit or loss on my 25 contracts many hundreds or even thousands of dollars either way. This is particularly true if implied volatilities happen to be moving at the same time. I know to expect this with the SPX, especially early in the trade, but also early each morning, when vols are dangerously plumped up. Many times, within a day of entering an SPX trade, it looks as if I'm at my first adjustment point when the SPX has moved only a point or two from my entry level.

Because I'm familiar with the way the SPX trades look on such charts, I know the prices I'm seeing are not truly executable prices. At times, I need to grit my teeth and wait before I leap into an adjustment. At other times, if technical analysis tells me that this likely isn't just an aberration but a big move getting underway, then I might need to go ahead and adjust early. Familiarity doesn't make me perfect at making choices. I sometimes adjust when I wish I hadn't, and sometimes don't when I wish I had. Yet, knowing what's going on with that risk-analysis chart based on my knowledge of how SPX strategies tend to behave--or, rather, misbehave--helps give me a little edge at least.

I don't know a thing about how strategies on that equity behave on a risk-analysis chart. Is "theoretical" more reflective of real life? Is it possible to execute most trades at the mark or is the trader going to have to give in five, ten, or even twenty cents off the mark to get that fill? In fast-market conditions, is there still enough liquidity to trade a spread or would it be better to hedge with a long call or put position, depending on direction, and then move or remove the spreads when the markets settle down a bit?

Lastly, is this an underlying that tends to behave fairly well with respect to trendlines, moving averages or the recognized technical analysis formations? For example, starting many years ago, I sometimes used the Dow Jones Transportation Index as a sort of weather vane. It didn't have options, but I was accustomed to watching how it behaves, and that behavior is relevant to this discussion. For a while a few years back, the TRAN tended to set up one bearish formation after another. It would confirm a technically beautiful breakdown, but those technically beautiful formations and confirmations couldn't be trusted. The TRAN was likely to turn around and zoom up, flattening every bearish trader in its tracks. I knew not to trust those breakdowns because I had watched the TRAN so long. Is this new underlying on which those traders had based their trade like the TRAN or did it behave beautifully with respect to the typical technical analysis tools?

Some traders run scans all the time, looking for underlyings that fit certain setups, but I want to know more about my underlyings than that. As you're examining your trade history and planning your trades for the next year, think about whether any of these factors--short float percentage, liquidity, tendency to gap, earnings and dividend announcements, technical behavior--have wrecked trades that should have worked out well. It might be worth your while to study a few underlyings and get to know them well, choosing among them for your preferred strategies. Consider saving the scanned-for trades for the lesser amounts of monies you devote to your speculative trades.