In early October, I decided that political uncertainty made it too risky to enter my November RUT butterfly trade at the usual size and time. By October 16, I thought it likely that we would have a deal by the end of the day, but not all i's had been dotted and all t's crossed. I wanted a smaller trade to reduce risk. I elected to enter with a 15-contract IWM trade rather than a 10- to 15-contract RUT trade.

Perhaps you remember from a discussion of the pros and cons of using ETF's such as the IWM that I would deal with several disadvantages when choosing to cut risk in this way. Although the risk would be smaller, so would the possible gains. However, I would pay the same amount in commissions, which meant that commission costs would make it more difficult to make a profit. In addition, I didn't get the tax advantages of the options on the bigger, broad-based indices such as the RUT. If I had any deep-in-the-money sold calls, perhaps as part of hedging call debit spreads, I would have to look up the ex-dividend date for IWM options as expiration neared, to avoid assignment risk. In retrospect, I might have been better off to enter a two or three-contract RUT trade hedged with long DITM IWM calls rather than the straight IWM trade.

However, for the purposes of this article, it's perhaps a good thing I entered as I did. I soon ran up against another difference that I had forgotten since it had been so long since I'd traded a straight IWM trade. What was that difference? Not all deltas are created equal. Let's look at what I mean.

15-Contract IWM Trade as EOD Adjustment Time Approached on First Day of Entry, OptionNET Explorer Chart:

Before I get further into the discussion, I wanted to note that I configured OptionNet Explorer so that the profit-and-loss figure includes two-way commissions, my actual commission costs to both enter and exit the trade. For this trade at entry, those two-way costs were calculated at $160.00, so the $168.00 loss was an actual $8.00 loss on the trade at that time plus the $160 commissions, including those to exit.

However, deltas were 42.05. That meant that for each 1 point that the IWM dropped, the trade would theoretically lose about $42.00 due to price movement alone. I don't like to keep my butterflies that positive deltas. I like for them to be at least slightly negative deltas. That's because they're hurt by a rise in implied volatilities (the negative vega tells us this), and implied volatilities tend to rise in a downturn. I would then have two things working against the trade if the IWM turned lower: a higher positive delta than I wanted and that negative vega. Accustomed as I am to the RUT's easy jumps of a standard deviation some mornings, I winced since the IWM is a RUT-based ETF, thinking that this trade could be in bigger trouble than I wanted on a big gap the next morning.

But, whoa, I reminded myself. While the RUT at that time had a standard deviation of +/- 12.36 points, the IWM's standard deviation at that time was only +/- 1.34 points. Even if I made no adjustments at all and the IWM gapped a standard deviation lower the next morning, the loss contribution from the positive delta would theoretically approximate $42.05*-1.34 = -$56.35. That wouldn't be a wince-inducing loss. If I'd closed the day with a RUT trade at a 42.05 delta and the RUT had gapped lower a standard deviation the next morning, the loss contribution due to the delta would be $42.05*-12.36 = -$519.74. Big difference.

The point? If you're switching back and forth from RUT to IWM or SPX to SPY options, remember to keep in mind the size of a standard deviation before you overcorrect a trade. The same is true if you're accustomed to trading AAPL and you're thinking about trading options on a stock that typically moves a couple of points a day. This point is especially pertinent if you're making the opposite kind of switch, from trading a stock or index with small moves to one that tends to move big. You may have to adjust your idea of what kind of overnight delta exposure you want.

Those who have forgotten or haven't yet learned the definition of a standard deviation or who need information about calculating it can find such information in this May 24 article. Linda Piazza