I started my options trading life the way many of us started in that period a little more than a decade ago. I began by day trading. In that milieu
, a trade either worked or it didn't, and it mostly worked if you were trading calls. Most of us didn't talk much about adjustments. Some didn't talk enough about stop losses, either.
Gradually, I began adding other trades such as verticals and the occasional butterfly or calendar. Due to some lifestyle changes a few years later, I wanted a trade that I didn't have to babysit every minute. I switched to trading iron condors. By this time, the markets were moving into a low-volatility environment. That kind of environment can present some challenges to the iron condor trader. Premiums taken in are smaller. The iron condor trader may be required to move the sold strikes in closer to the money or move the long strikes further away from the sold strikes in order to take in enough premium to make the trade worthwhile. Either of those choices presents more risk. However, markets behaved in fairly predictable ways most months. Employing technical analysis or even just having a reasonable prediction of where support or resistance might lie allowed the iron condor trader to set up trades with a high statistical probability of success.
With that kind of background, perhaps it was natural that I began to feel as if a trade that needed an adjustment was a failed trade. I hadn't timed the entry correctly or acurately assessed where support or resistance lay, I would often feel. I told myself that trades-gone-wrong were part of the business, of course, but it was hard to shake that other assumption, that I'd done something wrong.
The market environment was about to change again, and it was going to deliver lots of trades that needed adjustments. Whether we blame trading bots, QE programs, Greece or something else, the market environment offers fewer opportunities for adjustment-free trades. They still occur . . . occasionally. Due to my good luck in timing the trade, my JAN iron condor trade did not require adjustment. However, the market has delivered many more opportunities to inculcate the lesson that adjusting an options trade is just part of the business. It was the butterfly that changed my attitude. Charts like the one below were responsible for that change in attitude.
OEX Iron Butterfly with 30-Point Wings, OptionsOracle Chart:
This butterfly has the characteristic tent shape. The white box just to the right of the peak shows the then-current OEX price. The vertical green lines show one and two standard deviations from the current price. For more information about standard deviations and how they're calculated, you can refer to this December 25, 2009 article. About 68.2 percent of the time in a normally behaving market environment, the underlying's price will stay within a standard deviation either side of the current price. About 94.5 percent of the time under the same conditions, the underlying's price will stay within two standard deviations of its current price.
What does this chart show us and what does that have to do with adjustments? The blue line is the profit-loss line at expiration. This tells us that the expiration breakevens for the butterfly are not even a single standard deviation away from the current price. We don't need fancy calculations to determine that we're likely going to have to adjust this trade unless we want to accept an unhealthily large percentage of losing trades. Moreover, we're going to accumulate those losses more quickly in a rising market because the expiration breakeven on the right side of this chart is closer to the current price--and further inside the standard deviation to the upside.
You might think I just placed the wings too close.
OEX Butterfly with 60-Point Wings:
Doubling the wingspan on this brought the downside expiration breakeven a bit closer to one standard deviation to the downside, but the upside still remains well inside one standard deviation. Moreover, something else has changed. If you scan the two charts, you notice that the maximum loss on the second chart is far greater than the maximum loss on the first chart. In fact, the maximum loss on the first is $2,474, and, on the second, $5,039.
What we can gain from looking at this is the knowledge that the butterfly, by its very nature, is likely going to need adjustment unless the luck of the draw gives you one of those months when prices just sit in a tight range. Before you enter a butterfly, you need to have an adjustment plan in mind. Decide in advance what type of adjustments best fit your trading style: taking off the original and re-centering it, adding another butterfly at the expiration breakeven, moving some of the strikes, adding a long option or long debit spread, or some combination of those tactics.
Some butterfly traders even make their first adjustment moments after entering the trade. They might buy a long call position to even out the deltas and change the expiration graph so that the trade doesn't get hit so hard on any upside move.
This article wasn't meant to be primer on adjusting butterflies. That would take more than an article, and I'm not the expert on trading butterflies. What I'm suggesting, however, is that thinking about this trade in particular helped turned my thinking around and perhaps will yours, too. I extrapolated this truth about the butterfly to my other trades. A trade that needs adjustment does not signal a failure on the part of the trader who initiated the trade. Making adjustments and taking occasional losses truly are parts of this options trading business. Some trades are more easily adjusted than others. That easy adjustability is one of the reason I'm contemplating a switch from iron condors to butterflies for my negative-vega trades, but I know experienced iron condor traders who adjust with aplomb, too.
What's important is that the trader understand the likely need to adjust at some point, allot monies to do that, and adjust when needed. Understand that sometimes we'll adjust and the next hour or trading day will deliver a reversal that would have rendered our costly adjustment unnecessary. That's part of it, too. We're not prescient. In the long run, what hurts worse than making an adjustment it turns out we didn't need? That's when we let our mistaken feeling that we're failing when we adjust convince us not to make a needed adjustment.
Many of our trades are going to need adjustments. Period.