Imagine that it's 11:55 CT on December 3, and you decide to open a JAN at-the-money butterfly on the RUT. The RUT is at 820.95, and you choose a two-contract, all-put 870/820/770 butterfly.

Because at-the-money butterflies with wings equal distance from the center are always negative delta, you decide to cut that negative delta in half. That way, if the RUT takes off to the upside, the trade will endure less pain. For newbies to the Greeks of options, a negative delta means that the trade will be hurt if the underlying moves to the upside if other inputs stay the same.

You buy a JAN 890 long call. This raises the delta from -11.82 to -5.57. Over a short distance, the trade will lose $5.57 from price movement for each point that the RUT moves to the upside. Of course, other changes will likely be going on, too, especially with regard to the implied volatilities of the options. Also, that delta will get more negative as the RUT climbs, so the losses from price movement will start mounting unless something else such as a decrease in implied volatilities offsets them. For now, however, the losses from price movement will be minimal over small distances.

Original Options Components and Mid Prices at 11:55 AM CT on 12/3/12, via OptionsOracle:

Original Expiration Chart:

Your plan is to adjust by moving the butterflies if the expiration breakeven is hit. The current cost of the trade is $3720, including commissions of $1.25 per contract. You allocate $5000 for the trade, understanding that if it's necessary to move the butterflies, you'll realize losses on the original butterflies, bringing up your max margin. Your plan is to target a profit of 8 percent of the monies you've allocated to the trade, so $400. You set an equal maximum allowable loss, in case the trade goes against you.

That's your plan, and you're sticking to it.

On the upside, your expiration breakeven is 851.35, according to OptionsOracle. On December 19, the RUT nails that and even pushes slightly past it. Although the RUT pulls back by day's end, some damage has been done. According to OptionsOracle, you're now down $558.50, although another source I checked pegged the loss a bit lower, at $443.00. If this were an actual trade, we'd be able to check the actual options prices, but these are theoretical calculations and the sources may differ.

OptionsOracle Strategy Scan on 12/19/12:

That $558.50 loss shown on the Strategy Scan is beyond the maximum loss you've allowed yourself, and your maximum allowable loss was hit before it was even time for you to adjust, wasn't it? Not all of you will have traded butterflies this way, but I can attest that's not typical although it can happen.

Let's think about these rules a bit in connection with what was going on at the time. President Obama and House Majority Leader Boehner were sending encouraging signals about their efforts to resolve the first hurdle, at least, with the fiscal cliff. Greece and Spain seemed to have receded into the background. The RUT had been rebounding strongly from its November low. Just the previous day, the RUT had produced a 1.54-standard-deviation move, gaining 12.30 points and ending at 847.69, at the high of the day.

That previous day, December 18, when the RUT had made that 1.54-standard-deviation move and you knew the tenor of the markets, was there any doubt that 850 was going to be tested and maybe exceeded in the near future?

Of course there was doubt. The fiscal-cliff discussions could have fallen apart, and there certainly was some huffing about such a thing on December 19. But here's the thing: the RUT ended the day on December 18 very near the expiration breakeven, the delta was about -35, and the theoretical loss was already hefty, near 10 percent of the then-current margin in the trade.

Should common sense have come into play on Tuesday, December 18? Do you have to stick rigidly to your plan and wait until that expiration breakeven was nailed exactly before you adjusted? Should common sense ever come into it?

I don't let "common sense" persuade me not to adjust when an adjustment point has been reached. That good old "it's got to turn around" hopium is pretty easy to disguise as common sense. We're good at persuading ourselves that fear and reluctance to realize a loss are really just common sense.

While I don't let common sense persuade me not to adjust when I need to adjust, I do sometimes let it persuade me to adjust early or partially adjust on afternoons like that as the close neared on Tuesday, December 18. All it would take would be a gap and run higher the next day and the loss would likely be at or beyond the planned maximum loss that had been set.

Before making that adjustment just a short distance from the expiration breakeven, a trader could have asked some questions. What if the fiscal-cliff discussions broke up and the RUT dove the next day and kept diving? Wouldn't you be sorry you adjusted early? Of course, you would, but you're likely always sorry when you adjust immediately before a move reverses. But that's what happens. Sometimes we adjust just before a turnaround.

Unfortunately, common sense doesn't help you out much as it turns out, although the Greeks certainly make it look as if they would. Moving the flies to the new at-the-money level early, near the close on December 18, would have raised the delta from -33.55 to +2.90. Presumably, the trade would even benefit by a climb, at least over a short distance, and it wouldn't have been hurt much by a drop.

That's not how the adjustment worked.

Strategy Summary on 12/19/12, with Flies Moved Early, the Previous Day:

Yikes, that's still beyond the maximum loss you intended to take, although it must be noted that the loss is much less than it would have been without the early adjustment. Your common sense has ameliorated the loss, at least. My other source lists the loss now at $476.50, but here's other the thing that's troublesome: see the Maximum Loss Risk? Think of that as the margin or buying-power effect of the trade, what you have spent on the trade. That's also jumped above the planned maximum investment in this trade. Remember, you had set a planned maximum allotment of $5,000.

That's so high because the realized losses were so big when you closed out the in-trouble 820 flies. A whole lot of crazy volatility stuff was going on, on that big up day.

Let's go back to that whole common sense thing. Maybe you weren't thinking it through correctly on December 18. When the RUT was rushing higher, the trade was getting close to an adjustment but also close to the maximum allowable loss before it even got to the adjustment. Maybe another way of thinking logically would be to decide that instead of making the adjustment early, you should just close out the trade early. Unless one is a marvel of trading, moving flies in a fast-moving environment usually means that you're going to incur more slippage than is typical. That's not always true, but it sometimes is.

For some traders, closing out the trade early rather than standing on the train tracks and waiting for that car painted with the legend "max planned loss for the trade" to hit would be the logical thing to do. There's that risk that the markets could have turned around the next day, and the loss would have been locked in, of course. However, you can always reallocate your funds to a new trade when conditions set up for a more viable trade.

Were there other choices? I've known people who have, in situations such as these, bought a weekly to stabilize the trade so that they could wait for the developments the next day. Then they could reassess. For example, on December 18, a trader could have bought either an 850 or 860 Dec 12 (the monthly was serving as the weekly that week) call option. Unfortunately, neither option would prevent the trade from reaching beyond planned max loss for the trade. However, a DEC 12 850 call bought earlier, near the close on that previous Monday afternoon for $1.18, when the talk had begun circulating that a deal was near, would have served the purpose. At the close on Wednesday, December 19, 2012, the trade would have been down only 5.66 percent of the then $3840 max margin in the trade, only $217.50. The trade would have been very negative theta, at -92.48, however, and some decision would have needed to have been made that afternoon so that the decay wasn't experienced overnight. The point is that you'd have to have chosen the right day and the right weekly option and then dealt promptly with the theta hit in order to have benefited from this tactic.

It should be noted that the out-of-the-money long JAN 890 call bought to raise delta at the beginning of the trade was helping some, too, although perhaps not as much as hoped or anticipated. Purchased for $1.13 at the inception of the trade, it had a mid of $2.68 by that Wednesday afternoon.

We talked about the loss that was accrued even if the butterflies had been moved early, near the close on that Tuesday when the RUT ended near but not quite at the expiration breakeven. What would you have seen if you'd looked at the expiration graph instead?

Expiration Graph:

We see that the maximum loss is now more than $5000, our planned maximum funds to be devoted to this trade. However, we also see that the trade is nicely recentered, and that there's still plenty of profit potential between the new upper and lower expiration breakevens of 826.43 and 873.58. Is it possible . . .? Could you just hold on . . . ? Should you . . . ?

There's that hopium again. Actually, experienced butterfly traders can assess how viable the butterfly might be in the future. Some might elect to ignore the maximum loss because they understand that butterflies can and sometimes do reinflate, and the trade is so nicely centered with plenty of time yet to achieve planned profit.

Here are the hard, cold facts, however. You're in dangerous territory when you spend more on a trade than you planned to spend and when you start ignoring your planned maximum loss. That's not just one-trade-losing behavior: that's your-whole-account-eventually-lost behavior.

Don't do it unless you're experienced enough that you can tell that the losses you were seeing on December 18 were hooey. I haven't, of course, gone over all possible adjustments that might have been made. Some of them might have worked. Not adjusting at all certainly would have worked if the RUT had barreled lower on December 19 rather than risen again slightly. But you didn't know that on December 18 when you were seeing your maximum loss and your expiration breakeven closely approached, and you were--or should have been--playing around with various adjustments.

The truth is that sometimes bad stuff happens to your trades. Sometimes you have to bail. And sometimes you don't have to stand in the middle of the train tracks until the "planned max loss" car actually hits you.

As a note, this was not my trade. I don't set my butterflies up this way. I'm not currently adjusting them this way, either, although I have in the past and consider this setup a workable adjustment in many market conditions. Just not this month. However, everyone I know trading a butterfly this month has seen volatility-and-price-movement effects sink their PnL lines deeper and deeper below the flatline, no matter what their adjustment methodology, and this is an easier setup to illustrate than my more manage-by-the-Greeks way of trading. Back test any trading methodology you're considering.