Few parents have survived their first years of parenthood without asking that question of their children. We learn to address the biggest hurt first. Sometimes, when we're trading complex positions, we need to ask ourselves what portion of that complex trade is hurting the position.
Let's use some simplistic examples to illustrate the point. You can apply the tactics shown here to more complex examples. For example, perhaps you might have combined a vega-negative trade such as a butterfly or iron condor with a vega-positive one such as a calendar, and you need to puzzle out which adjustment makes the most sense.
Let's start with a simpler example: a standard high-probability iron condor theoretically established on April 23. Implied volatilities had popped and the SPX was poised at what should have been either strong support or a stepping-off point for a steeper decline. If you're about to establish that trade, you don't know which, and you don't care. You just want to establish a trade that's relatively neutral at inception.
I haven't traded iron condors for several months for many reasons, one of them being the low credit that you can receive for selling iron condors when the implied volatilities are so low. I prefer to receive at last $1.20 per contract and prefer $1.30-1.45. However, for the sake of illustration, let's imagine that we established an 1440/1430/1245/1235 iron condor by selling the 1430 call and the 1245 put, and buying the 1440 call and 1235 put to hedge. For those who like to study the Greeks, I sold the first call with a delta below 10 and the first put with a delta higher than -9.00. (Note: For those not comfortable with negative numbers, a put with a delta of -8.80 would have a delta higher than -9.00. The nomenclature gets confusing for some.)
Here is the theoretical position:
The Strategy Summary from OptionsOracle:
The trade perks along pretty well the first couple of days, but by April 26, the trade is in trouble. It's down 7.46 percent of the margin withheld for the trade. Unfortunately, I can't roll freeware OptionOracle's date backwards to show you a profit-and-loss chart for that date, but the trade was deeper trouble by April 27, the date this article is being roughed out. I'll use April 27 as a test for what's going wrong.
The T+0 chart, the "today" profit-and-loss chart, is shown below. A red dot pin points where the price is along the profit-and-loss line for the day. At the middle of the afternoon that day, the trade showed a loss of $97.50 or 11.00 percent of the margin withheld. Chart sizing requirements don't allow me to show the OptionsOracle scale that calculates that percentage loss, but it can also be calculated by dividing $97.50 by the total $895 total investment shown in the Strategy Summary graph. That number includes commissions on the trade, and obviously needs to be adjusted to reflect lower commissions most of us can procure, but I didn't notice that it hadn't been adjusted for this trade until the simulated trade was underway.
That $97.50 is a much heftier percentage of the $105.00 maximum profit potential for the trade.
T+0 Line for April 27:
Some traders would point to the fact that, at just above 1400 at the time that chart was snapped, the SPX's price was still far away from the sold 1430 call. In addition, there was much time before expiration. There was no need to panic. However, conservative traders who prefer a different adjustment strategy would note that the T+0 line drops quite steeply as the price moves higher from the April 27 level. Potential losses soon exceed any possible gain from the trade as the prices move higher. What if the SPX continues higher? Is there a way to figure out what portion of the trade is hurting the trade and causing the most harm?
Obviously, we know what's hurting this trade: it's a widening of the call credit spread as the price of the SPX climbs. Anyone who has traded iron condors understands this intuitively and doesn't need to isolate the cause on a profit-and-loss or analysis chart. Specifically, what's happening is that the price of the closer-in sold 1430 call is rising faster than the further-out 1440 call. The iron condor trader sold that spread for a certain price but would have to pay far more now to buy it back and close the trade. What if the trade were more complex than that, however? Is there a way to figure it out, specifically if the trader didn't know a lot about Greeks?
Charting the components of the position can help. The intent is to use a reasonably familiar position in this article and show the process. Using OptionsOracle, I can uncheck the call portion of the trade and determine what's happening with the put portion.
Put Spread Profit-and-Loss T+0 Chart:
Obviously, this portion of the trade will not prove problematic if the SPX price keeps rising. If price rises, this portion shows more profit until the the profit flattens off as the spread narrows further.
As price drops, the T+0 line shows some profit for a small distance. After about 1340, it drops more precipitously. This is theoretical, of course, and doesn't show how this trade would be impacted by rising implied volatilities, which tend to rise when prices drop. However, our goal here is to use this simple position to demonstrate how we might find the part of the position causing the most trouble as the SPX was rising that day.
Unchecking the put spread and studying the T+0 line for the call spread shows a much different line, of course.
T+0 line for the Call Spread:
Isolating this spread tells us that the trouble in the profit-and-loss line to the upside is coming from this spread. Of course we knew that. Isolating each of the options individually would give us even more information. In the case of the iron condor, particularly a single-contract iron condor, the trader might have elected to simply take the trade off when it reached a certain preset loss amount, since it's hard to defend an iron condor in a strong upside move. Perhaps the trader who was watching this every day would have elected to hedge in some way before the loss reached this level.
While this information about the portion of the trade causing problems might be intuitive or logical for this trade, it might not be so intuitive or logical if you've set up a trade with a mixture of strategies. Perhaps you have a triple butterfly with an extra calendar in the middle to lessen the volatility risk. Is the damage coming from that calendar or from one of the butterflies?
In the case of the simple sold iron condor, something needed to be done with the call side. Maybe in the case of the triple butterfly with an embedded calendar, the trader would find out that sinking implied volatilities had lowered the value of the calendar, causing a problem. Or perhaps the butterfly farthest out of the money had negative theta, which would show up on the Strategy Summary, and was losing money from time decay every day.
I use the Greeks as well as such PnL charts to help me determine which portions of my trade are in trouble. Still, sometimes I forget to watch out for when theta goes negative in each butterfly in a trade which has multiple butterflies at different strikes or this sort of thing. For those new to trading complex strategies, it can be even more important to watch the separate components of the strategy. Some new traders have never thought about looking at what the separate components of a trade are doing.