At the end of July last year, the Russell 2000 closed the week at 797.03. During the next week, the RUT hit an intraweek low of 698.60, a 12.35 percent drop in one week. The RUT managed a weekly close at 714.63.
Why am I telling you this? I trade RUT butterflies as my main income trade. I closed out my DEC version and locked in profits before the elections. On November 7 and 8, I was studying pricing on JAN butterflies. Specifically, I was acquainting myself with the going price at that time, watching various setups on an analyze screen, and studying charts to determine where I thought resistance and support might lie so I could choose the setup that best matched what I was seeing.
In the Monday Wrap from November 5, I had warned that the RUT had set a lower target and could, if it broke through that target, quickly hit a much lower target. Below, you'll find the original RUT daily chart from that November 5 Wrap.
RUT Chart from Wrap on November 5:
Remember that this chart was snapped and appeared on my Wrap November 5, so it's not an updated chart showing current prices. It is, however, showing what I was thinking that Monday, leading into decisions I made later in the week.
For a couple of weeks leading into that November 5 chart, I had warned that if the RUT dropped through the bottom of that lower orange rectangle, it would then be setting a potential target down at the lower red rectangle. I also warned it could hit that target quickly.
By November 8, when I was deciding whether to enter a new RUT JAN butterfly position, the RUT was hitting the lower end of that orange rectangle visible on that chart. Consistent daily closes below that rectangle, if they should happen, would set up that potentially much lower target. When the Keltner setup looks like this, those lower targets are sometimes hit fast.
I typically set my butterflies up below the current price, and I move them if the RUT barrels through the central sold strike by more than 20 points. I buy deep-in-the-money calls to even out the risk if the RUT instead takes off to the upside, and, because I'm a cautious sort, I always buy an "Armageddon" put, an out-of-the-money put that would inflate in value due to changing skews if the RUT barrels lower. It's not meant to protect the trade from all losses: that would cost too much. It's meant to protect me from losing all the monies invested in the trade and/or to steady it while I make the adjustments I want to make. So, even a move of that magnitude, from the orange rectangle down to the red one, was manageable, if it happened.
However, a wider look at the charts showed me another possibility that might not quite so manageable or at least comfortable to trade.
What I was seeing was some similarities in the weekly chart of the summer of 2011 and the then-current setup.
RUT Weekly Chart at EOD, November 8:
My own outlook for weeks had been that if the RUT produced consistent daily closes below about 797, that it risked a quick drop into the 730-735 area. This weekly chart showed the possibility of a quick run much lower. It didn't promise that the same kind of drop would happen. On the way up late last year, the RUT had chopped out some possible support zones that could provide some ledges that would break its fall. However, this chart did provide a warning of the kind of thing that could happen and had happened in the same price zone.
The question, then, was do I enter the trade or wait? Obviously, with 70 days still to go until Jan expiration at that time, I had time to wait. I had begun by entering this trade at about 58 days to expiration and had gradually been working it backward, further away from expiration. I don't like to trade in the two weeks before expiration and this allowed more time for the trade to work while keeping me away from that two-week period.
As a former trading partner used to remind me, we're traders and we trade. There's always something scary going on in the world and, therefore, in the markets. "Potential" targets are not the same as iron-clad targets. If we always eschewed trading whenever there was a potentially strong move either to the upside or downside, we wouldn't be trading much. My trade is well-hedged.
The converse of that is that my trade is set up to manage well if the RUT stays within certain parameters. Few butterfly, iron condor or calendar trades are meant to function well with the kind of move seen that first week of August 2011. While we should develop a trading pattern that allows us to trade month after month if we want to produce an income, aren't there times when all the stars align to show that it's just foolish to plunge in with the same trade because that's what you always do?
I actually had no angst about my decision, but I am illustrating all the thought processes that many a trader goes through when such situations present. Following the conversations of other traders, I noted that they were weighing the same "should I" decisions. Some were deciding to skip a month, enjoying their Thanksgiving dinners without worry about their trades. Some were plunging forward.
Others were suggesting what I would suggest to our readers and have done over the last few months. My suggestions would have begun by warning that if you have traded only this calendar year, you have not yet been through a decline of that magnitude. If your trade has been performing well this year, then it's been performing well under different circumstances, and it may not perform so well under conditions which include exploding implied volatilities. As I've been warning in my Monday Wraps and sometimes here, too, a setup like this was not the time to continue scaling up in size. It was time to consider scaling back for a month, adding that cheap out-of-the-money put, or otherwise managing a trade so that the trade wouldn't lose more than a trader can afford to lose in a rout. I'm not just talking about losing money, either: I'm talking about losing confidence in yourself and your trade.
Some traders even switch the type of trades they'll trade if they believe a big directional move is about to take place, perhaps employing a directional trade such as straight option purchase or a credit spread, debit spread, straddle or other such trade. I would suggest some caution in adopting this tactic unless you're experienced with the directional trade you're considering temporarily adopting.
I knew my decision. I had plenty of time to observe for a while before opening a new trade. Depending on what I observed, I would open it in my usual size, a smaller size or even not at all. Be aware that I was taking a risk by waiting, too. The fly that was available for $12.50 on November 8 might cost me $13.50 by the time I feel confident about moving into the Jan expiration period.
As it turned out, the RUT did barrel lower although it has at least not yet hit the 730 zone. What did I do? I waited until the RUT dropped far enough that I could position my flies/DITM call/OTM put position to handle the further drop into the 730 area, if that should occur. They could also handle a bounce back to 810-820 if that should occur. I could watch that support or resistance test without incurring terrible losses and then make a decision about adjustments. I also elected to whittle the trade down to half size. I've traded through many a downdraft through the years, but I haven't traded through a real market rout since I switched from iron condors to butterflies. I also worked that order until I got what I thought was a reasonable fill, based upon the pricing that I had been watching for a week. I don't know whether I'll manage another profit this month or not, but I know that, whatever happens, I'm unlikely to lose more money than I make in a typical month, much less more than I can afford to lose.
If I were a newer trader, I'd either have paper traded this month or knocked the trade back to one or two contracts. Good luck making your own decisions about how to control your risks in the current market environment.