Last week's article imagined the case of someone who opened a four-contract iron butterfly on the RUT on April 11 but then got scared at the end of the day. Rumors floating around that the markets might be due for a strong pullback worried the hypothetical trader.

The original position had been an iron butterfly at the following strikes and prices:


Note: As I mentioned in my prior article, I didn't notice that when the first chart was snapped, I had included one OEX call with the rest of the options being the XEO options. I corrected that later, but forgot to re-snap this picture. Prices for the XEO and OEX options at that strike were comparable, so the mistake didn't change the thrust of this article.

The original position at expiration would have looked like this:

One of the possible adjustments to lower risk in case of a steep decline was an extreme one, to take off one 625/595 put vertical by buying back one of the sold 625 puts and selling one of the long 595 puts. This increased the original margin and also changed the expiration breakevens. OptionsOracle lists expiration breakevens at "Lower Protection" and "Upper Protection" on their "Strategy Summary."

Strategy Chart for Adjustment:

The new expiration graph showed that this adjustment lowered the risk to the downside if markets rolled over.

New Expiration Graph as of April 11:

The adjustment turned out not to be needed. The OEX's volatility increased, with the index producing big moves that tended to be reversed the next day. Prices might not have changed much over the course of a week, but they certainly did from day to day.

What was the result during the last week of the April expiration cycle? Although the XEO and OEX options trade through expiration Friday, I don't like to carry trades that far into expiration week, even if the trade was a short-term trade. I tend to set a profit target and get out when that is reached, too. If our hypothetical trader had set a profit target of 10 percent, would hedging the trade have ruined the possibility of reaching that target?

Freeware OptionsOracle is good for many things, but I would have had to follow the trade through day by day to determine when it hit a 10 percent profit target, if it did. Instead, I checked on a proprietary charting provider that does allow me to look back at real-time prices. That shows me that a 1.40 standard-deviation move on Thursday, April 12 jammed the OEX's price up near the expiration breakeven and resulted in a theoretical loss that day of 11.7 percent, a hefty loss. Likely, it would have been time to either adjust that trade again that day or else take it off, whatever the hypothetical trader's plan for dealing with adjustments might be. There's no single one right or wrong way. Much depends on a trader's risk tolerance and outlook and the relationship of the size of the trade to the size of the trading account. However, the point of this particular article is to follow through the original trade adjustment and see how it impacted the trade, so let's go forward.

The 10 percent target profit was theoretically hit to the dime, on Monday, April 16, but that's not considering any slippage. When we're backtesting, we should always assume we'll suffer slippage when exiting a complex trade. One frequent RUT butterfly trader I know assumes she'll lose about $150-200 in slippage per butterfly when she exits a butterfly trade, but that includes closing all the hedges she includes in her particular trades. She's a frequent hedger, so each butterfly contract may have additional long options or debit spread contracts to exit, too, as part of the trade. Her estimate of slippage per butterfly may be a bit higher than many traders experience.

I still likely would have exited and been thankful for what I could have earned, especially since the Friday before showed such a large unrealized loss. However, let's assume that our hypothetical trader wanted to milk the trade until that profit target was reached. By the next day, a higher profit was available in the morning, but by the close, an all-day climb had erased all but $33.50 of the theoretical profits. The decline on Wednesday of expiration week brought them back again, in spades, with more than enough padding to take care of any slippage and still produce a 10 percent gain.

What if that adjustment, that hedge, had not been placed at the end of the first day of the trade? Thursday, April 12, when the adjusted trade suffered an 11.7 percent loss near the close, the unadjusted butterfly had a 3.70 percent gain. That makes sense. Remember in the last article, we had noted that the adjustment lowered the upside expiration breakeven. At each point on the upside, the unrealized loss would be larger than it would have been without the adjustment.

Monday, April 16, when the adjusted butterfly hit the profit target, so did the unadjusted one. They were only a few dollars apart, but because this unadjusted trade had a lower margin, it produced an 11.22 percent gain on the margin. That was probably enough to exit and keep most of the 10 percent profit after slippage. On Tuesday, the 17th, when the strong climb took away all but $33.50 of the adjusted trade's gains, the unadjusted one also suffered a bit of a reversal, too, but ended the day up $246.00 or 3.30 percent. As was true with the adjusted trade, the next day's decline brought the gains back in spades and probably could have produced a 10 percent gain, even after slippage was included.

What's the lesson? One of the most important lessons must be to be careful of the temptation to overadjust. Overadjusting to protect against a possible perceived risk on one side can force another adjustment. If the markets move in the opposite direction, an adjustment will be needed sooner than it would have been needed otherwise. Although I was not in an April trade during the period covered by this article and I'm not currently trading the XEO or anything so close to expiration, I did adjust a May trade during this same period. I tried to make my adjustment as conservative as possible. However, as happened with this more radical adjustment in this hypothetical butterfly, my adjustment did force another that wouldn't have been needed if I hadn't adjusted the first time. Sometimes we'll be right when we make an adjustment, and sometimes the markets will reverse on us the moment we do and the adjustment wouldn't have been needed. Since we're not prescient, events like that are just part of the business of trading. However, it might be wise to make the most conservative adjustment that you can make that still protects the trade.

Another lesson, of course, is that the trader who falls prey to worries when hearing rumors about the market should perhaps turn off the television, online news subscriptions and chats. That trader should go back and rethink the reason why the trade was opened and the planned adjustments.

I mentioned last week that although I used to trade XEO butterflies the last week to ten days of the expiration cycle when I thought the conditions were right, I no longer do that. Market conditions have changed. Markets can be more volatile and even indices--especially indices, sometimes--can gap in the mornings in ways they rarely did in the early 2000's. I prefer now to close my trades before expiration week rather than open them about expiration week, so I'm obviously missing out on all the fun and danger, too, of trading the weekly options. The results shown above for both trades demonstrate some of the reasons why I'm choosing to miss out, with the profits and losses volatile from one day to the next. Many among you are happily trading the weeklies, enduring expiration week every week, but newbie traders should understand that extra risks attend these types of trades. Profit or losses can be volatile.

Another lesson is that charting systems such as OptionsOracle, some brokerage charting systems and proprietary subscription-based charting systems allow you to test possible hedges that might help you weather a big gap the next day. Almost all such systems, free or expensive, allow you to roll the date forward and change price and implied volatility levels. With the exception of think-or-swim's Think OnDemand, a system I haven't mastered, only the more expensive ones allow you to roll the dates backward, however. Perhaps others exist, but I haven't learned about them. If you don't have one of those subscription-based systems that allow you to back-test a trade and watch how it unfolds day to day, I urge you to set up some potential trades that you might be considering and follow them through a few cycles on your brokerage's simulator or on something like freeware OptionsOracle, testing adjustments, seeing what the pros and cons might be. If our hypothetical trader had hedged against the possible downside slide, that trader probably would needed to make other adjustments on the days when the OEX zoomed up. In OptionsOracle, traders can save the original setup as well as the original setup plus an adjustment and follow the two through day by day, comparing how they fare.

Don't depend on making the profits you see on these theoretical charting programs. Slippage, panicked decisions, and market makers who won't take your adjustment orders in fast-market conditions all render live trading conditions more thorny than theoretical calculations. However, if you find that you can't make money on a certain strategy in one of these programs, then do trust what you've learned.

The main take-away point is that you don't have to concentrate on the Greeks if you're a visual person and just want to see charts. I happen to think the Greeks are valuable and can show you some advantages and disadvantages, but you're using the Greeks in a different format when you use these charts. Happy charting!