The last four articles have dealt with some of the basic decisions options traders make when moving from the straight buying of calls and puts into more complex positions. Some of those decisions include the following:

Which strategy?
Which underlying?
Which strikes?
What size and/or how much money to allocate to the trade?
How many days to expiration to begin?
Adjust or take off when it goes wrong?

The articles have focused on comparing and contrasting iron condors and butterflies. Ideally, the calendar would also belong in this list of theta-positive, income-type trades. However, although I can toss off information about the construction of calendars, I somehow can't make calendars work for me with consistency.

When those vol crushes come, sinking the profit-and-loss line of the vega-positive calendars, my calendar trades don't seem to have great success at recovering from the effect of that crush. For that reason, I'm not going to be discussing calendars even though others trade them with regularity. I know quite a few active traders who employ calendars as their primary trade, and I know quite a few other active traders who are as wary of them as I am. The ones making consistent profit from them should be talking about them, and that's not me.

Prior articles have already concluded that iron condors have less profit potential for the same amount of risk when compared to the butterfly. That so-called benefit to the butterfly is offset by the fact that butterflies will almost certainly need to be adjusted with more frequency than iron condors. That disadvantage of the butterfly is in turn offset by the higher possible profit, leaving room to make those adjustments and still rake in a profit. Not all butterflies will be profitable, of course, and, when managed well in reasonable market conditions, iron condors prove profitable trades. The theme of all these discussions is that there is no one best trade for all traders and all situations. You might be the trader who doesn't want to adjust or at least adjust frequently, while others might be the kind of traders who will willingly adjust to keep the profit-and-loss line relatively flat.

Last week's article discussed some of the difficulties that can arise when it's time to adjust an iron condor, particularly in a runaway market to the upside. In that case, diving implied volatilities make it expensive to roll the in-trouble call credit spreads further out of the way.

Adjustments after prolonged upside moves can be difficult on the butterfly, too, although they're often easier than those made on the iron condor. As this article is roughed out on February 7, 2013, the original butterfly setup we had used in the last several articles was showing profit. Depending on the trader's feelings about the delta risk, it might not have needed adjustment as this article is roughed out.

Original Butterfly Setup, Carried Forward to 2/7:

The delta on this position is visible in the "Live" middle line. It measures -27.45. Some traders would feel comfortable with that risk as long as the price was well inside the expiration tent. Others would take a look at the sharp downward curve of that white T+0 line as prices rise and want to flatten that line a bit. Whether you think of the process visually, as flattening that T+0 line, or whether you approach it from a Greeks standpoint and think of it as raising the delta so it's not so negative, the effect would be the same. The idea would be to prevent the loss from escalating too quickly if the OEX jumps up over the next day or so.

Note that the current maximum loss in this trade is just less than $3,000, at $2,940 plus commissions. One of the decisions traders must make when deciding about complex options positions is how much risk we want in our portfolios.

This butterfly was an iron butterfly, composed of calls and puts. It was originally constructed as a split-strike iron butterfly with the sold calls at 680 and the sold puts at 675. This butterfly was constructed as a split-strike version because the OEX was near 677 at the time the hypothetical trade was first set up. The wings were the same size, 30 points on either side of the sold options.

One possible adjustment is to do a condor roll of the call credit spread portion of the butterfly, moving the sold call and the long call positions out 10 points. The original call credit spread was as follows: -2 MAR 13 680/+2 MAR 13 710's. The adjustment would be a condor roll as follows: +2 MAR 13 680/-2 MAR 13 690/-2 MAR 13 710/+2 MAR 13 720. This would result in a new call credit spread of -2 MAR 13 690/+2 MAR 13 710. The wing width remains 30 points, so there is no problem with an unbalanced trade. Remember that with the way FINRA rules are enforced, each wing might be margined separately if the wing widths are not kept the same.

The other advantage to doing the condor roll is that it's a single trade rather than buying in the original call credit spread and selling another one further out, which would be two trades. That opens up more opportunity for slippage, particularly in choppy market conditions. Here's how the trade and Greeks would look.

After a Condor Roll of the Call Credit Spread on February 7:

Looking across at the Greeks, we can see that Delta is now 2.95, which means that over a short distance, at least, profit won't be much impacted by a price move. Neither will the trade benefit a lot by price movement. Theta, the component that measures how much the trade benefits from the passage of time, remains close to the original level. So does vega. The trade has been inoculated from price movement without too much damage to the other Greeks. If a trader prefers ignoring Greeks and watching the white T+0 line, the line illustrates that price can now move up a bit more before that line starts sloping down too steeply into loss territory.

We notice, moreover, that the potential profit at expiration remains high. This is unlike with the iron condor, when adjustments may cut deeply into profit potential. So what are the cons to this, the disadvantages? Notice that the potential maximum loss has deepened. The cost of the adjustment has been added to the original cost for the butterfly, comprising the maximum loss. The potential maximum loss is now $3,760 plus commissions. Butterfly traders, like iron condor traders, must decide how much they're willing to invest in butterflies before they initiate the trade. This adjustment didn't cost too much when compared with the potential profit because it was put into effect early, but if the trader waited until the price had moved significantly higher, that adjustment would have cost more.

In addition, expiration breakevens have changed. Raising the delta shifted those expiration breakevens to the right. The trade will get into trouble sooner on a downside move, although the shift wasn't a large one.

The original butterfly trade had consisted of two contracts. Other potential adjustments are available. The trader who wants to adjust could buy back one of the iron butterflies and sell a new one higher up to raise that delta. The following chart shows what happens when one of the original iron butterflies is bought in and a new one at the 690 strike is sold.

Second Theoretical Adjustment:

The delta is again flattened. Theta has dropped a bit more than with the condor roll. The new maximum loss is $2750.00 plus commissions, much lower than with the condor roll adjustment. The trader has traded a smaller maximum loss for less theta when choosing this adjustment over a condor roll of the call credit spread. The trader who wanted no more than $3,500 at risk in this trade, as one figure pulled out of a hat, would prefer this adjustment over the prior one, but the trader who wants out of the trade as quickly as possible and who set a $5,000 maximum loss might prefer to keep the theta beefed up.

The butterfly is so flexible that it's impossible to cover all possible adjustments. Some subscribers might be saying, why not just buy a long call? The problem with that tactic is that in a continued rally, the implied volatilities might come down. Such a drop in implied volatilities hurts the value of a long call. Furthermore, a long call is a negative-theta trade. The value of a long call decays with the passage of time. Buying a long call would subtract from the positive thetas the trade has accumulated. In other words, the long call might not be as helpful as it appears that it would be although I'm certain that some traders and even some of our subscribers have, on occasion, used the purchase of a long call to good effect to hedge their butterflies. Just be aware that time and, likely, implied volatilities are undermining the good effects of rising prices in a long call purchase.

Some traders employ call debit spreads instead. Here's an example, set up by adding a +680 MAR 13/-700 MAR 13 call debit spread to the original trade from the first chart. Traders could choose OTM, ATM, or ITM call debit spreads, with pros and cons to each.

Third Adjustment Idea:

This trade has raised the delta. The "today" or T+0 line shows the more even balance of the trade. The maximum loss to the downside is now $3635.00 plus commissions, while it's lower on the upside, $1635 plus commissions. This is not, however, an unbalanced butterfly that will require margin on both sides. This is a balanced butterfly with the extra cost of the call debit spread reflected in the increased downside risk.

Each adjustment has pros and cons. What are the pros for this one? Notice that the negative vega risk has been ameliorated. This trade isn't going to suffer as much from an increase in implied volatilities, at least theoretically. The expiration breakevens have shifted to the right, as they likely always will in any adjustment meant to raise delta. It's a costly adjustment and may be too costly if a trader were trading only one contract rather than the two pictured here, although the trader could buy a narrower debit spread, of course.

We still see plenty of profit potential. However, these potential adjustments were all set up in the course of a few hours, while markets were relatively quiet. If the OEX had been soaring upward with implied volatilities diving, those butterfly and condor rolls would have cost more and the maximum potential loss would have grown more.

Some general thoughts about butterflies as compared to iron condors are that, while the butterfly will generally need to be adjusted more often, there is more profit to buffer the cost of those adjustments. Many potential adjustments can be applied, as it's a flexible trade. Depending on how the butterfly is constructed, it's a bit more forgiving of a trade although it won't forgive a trader who trades with the view that "it's got to turn around, so I'm not going to adjust" when an adjustment is needed.

However, the butterfly trader must be careful about the margin employed in the trade. Some adjustments on some platforms can result in a doubling or even tripling of the original margin in the trade. Traders who want to employ butterflies should talk to someone at the trading desk on their trading platform to learn how various adjustments will be handled. Don't trust simulated trade setups: sometimes the actual margin is different than that shown on the simulators, particularly if it's a simulator not attached to your brokerage.