On the morning of February 2, 2012, I was looking at adjustments for my FEB12 RUT butterfly. I imagine I wasn't alone. On that morning, the trade was down but only about 4.5 percent of the amount I'd spent on the trade. The loss was not approaching my preplanned maximum loss for the trade. However, I knew the jobs number was due the next day, and I wanted to make sure my low delta stayed low until I could see how the markets would react. I didn't want to get caught flat-footed the next morning. It was time for an adjustment.
I had 720/770/810 broken-wing butterfly, with the wings 50 points away on the downside and 40 points away on the upside. I had done this so the protection of the upside long would kick in sooner in what was a runaway market to the upside. It was my intention to use a butterfly roll (770/810/840) to roll out the 770/810 part of the butterfly to the 810/840 strikes and then add a 780/790 call debit spread to further flatten out risk to the upside. (Note: those who don't understand what I mean by "butterfly roll" should look at last week's article that explains the term.) Those adjustments were going to cost me.
At the time, the 770/810/840 butterfly was quoted at $8.15, and the 780/790 call debit spread was quoted at $8.85. That means that I was going to pay at least $815 plus commissions for each butterfly contract I rolled and $885 for each call debit spread I bought.
My original debit on the trade when entered was $5,184.60. Although I don't have the depth of experience trading butterflies that I do on iron condors, I know that butterflies have this pesky ability in Reg T accounts to escalate in margin or buying-power effect when they're adjusted. I'd planned for a total investment of up to triple my original investment. Those adjustments I planned plus all the others I had previously made still left me plenty of leeway.
What if I'd begun this trade in an account with $10,000, however? Leaving about half of the account in cash, available for adjustments may seem like plenty. Not so, if I wanted to adjust in this manner to keep the delta as flat as possible. If I'd attempted a 3-contract RUT butterfly in that size account, I would have been able to place the trade initially, but the amount of cash I had left over would have constricted the number and types of adjustments I could make. On that day before that announcement, I might have been restricted to either leaving the trade as it was, selling the butterfly I had and only then buying another one with a different central strike or maybe just buying a long or long debit spread.
This constriction in adjustment possibilities if too little cash is left is true of many types of trades, not just butterflies. What if, in the case of an iron condor, an adjustment required me to buy in an in-trouble spread as part of the adjustment? When you buy in one side of an iron condor, you still have a margin requirement for the credit spreads on the other side, plus you reduce the cash in your account by the amount you spend buying back the in-trouble side. If I'd left too little cash to account for such a development, I would have no choice but to close the whole trade down at once, locking in the loss. This week, as I was editing this previously roughed-out article, I talked to a trader in a trading group who wasn't able to make the adjustment she preferred because she didn't have enough capital left over to do so.
Another concern for those who trade too large for their account size is overlapping trades. While I was still in my FEB butterfly, for example, the time had arrived for me to begin my MAR one. That might be true for many of the trades you're considering, too. While I'm still trading small enough as I test the way I want to manage butterflies that it's not a problem, I will certainly have to give this topic some consideration if I decide I like this trade and begin a process of sizing up to produce the wanted amount of income.
These are simplistic examples, but these concerns are swamped by a bigger one: what can happen to your account if you have too big a percentage of your trading capital tied up in any one trade. Through my years of trading and talking to other traders, I've gradually come to the conclusion that the "impossible" event--whether market related or trade-management related--is much more likely to happen than you believe. You carry a trade into expiration week, and there's a huge gap higher and run up with volatilities escalating instead of dropping as they usually do during a climb, and your iron condor or butterfly trade suffers a devastating loss much bigger than the planned maximum loss you'd intended to take. I've watched this happening in the prior months to many traders who trade the weekly options. You put on a 60-contract iron condor trade the day before the Flash Crash. That one happened to me. Whenever the impossible happens, you want to make sure that your trading capital is only diminished, not wiped out. Spreading out the trades into different vehicles across different time periods helps, but give much consideration to whether you want to have too high a percentage of your trading capital tied up at any one time. The more runaway a market, the more likely you're going to make expensive adjustments and the more capital gets tied up in a trade.
The "impossible" event becomes even more possible when you factor the emotions of trading into the equation. It's far easier to manage a trade that's going wrong if the capital involved is 10 percent of your trading capital than it is if that trade represents 75 percent of your trading capital.
Again, I've provided simplistic examples, but I wanted to give a realistic, drawn-from-my-actual-trades description of what might happen to the cash needed in a trade, using that butterfly example. What happened to that Februrary butterfly that I was adjusting on February 2? As that February day went on, I elected to make the adjustment in half of the contracts I held. The quotes from that morning had been $8.15 for the butterfly and $8.85 for the call debit spread. I wasn't able to fill the call debit spread for anywhere near the mid or mark, so I elected to buy a DITM IWM call instead. I was able to get the butterfly at the mid or mark, but the mark had moved up to $8.60 later in the day, with the RUT hovering near 810 at the time. That adjustment helped the trade weather the next day's rabid rally without losses mounting too heavily while some people I knew in the same trade hit their planned maximum loss on February 3. That next day's action required another decision, however. Did I plow more capital into the trade to make another adjustment or did I close down the trade? Several factors went into my decision to close down the trade for a loss of 5.75 percent of the maximum buying-power effect incurred during the trade. Although I'm trading only three contracts now and the account can handle many more contracts, I'm making the decisions as if I had already scaled up into twenty contracts. If I had twenty contracts and not just three, would I want to keep plowing more money into a trade in the hope that the underlying would settle down or even pull back some, just based on the thought that surely it had to do so soon?
That's not my style. Even though my technical analysis skills were telling me that the RUT's climb was overdone, with RSI levels in the stratosphere, the trade had become a directional bet rather than the neutral-type trade that I wanted. The adjustment the day before had minimized my losses, so I could get out with a small percentage loss. I deemed it was better to round up the money I had left in that trade and concentrate my funds and energies elsewhere. I did follow the trade through via simulated trades to the pullback early this week. The unadjusted trade would have had a small profit.
Shoulda, woulda, coulda? Nope. On February 3, the RUT had broken out to the upside out of a rising price channel in which it had been traveling for quite a while. When the RUT dropped down the morning of February 7 to test what had been the top of that channel, it bounced again, showing that the top of that formation was now serving as support. That bounce eventually failed and the RUT dropped back through that channel again and fell out the bottom. However, if Greece and the EU had come to some agreement on that weekend of February 4 and 5, we could have woken up to another rally that Monday morning that pushed the RUT back above the February 3 high. I personally wonder if we haven't already had the post-Greece-decision rally, but the markets haven't consulted me yet about their behavior and I am not prescient, so I make the best decisions I can make in order to preserve my trading capital. January's trades had been profitable and hopefully, March's will be. Losses are part of trading. It's my job to keep them small enough that they don't wipe out the gains from profitable months.
However, if I had decided that I could adjust that trade in a way that made me comfortable with that weekend's risk, then I would have done so. I had left plenty of money in the account to do so. We all need to make sure that we have enough buying power left in our accounts that all our choices are available to us.