If volatile market conditions have led me to take a number of quick profits in a row, what else should I consider? If that practice has continued for more than an isolated trade or two, I should consider altering my planned maximum loss, too.
Why is that? If my planned target profit for my butterfly trades is $250-300/butterfly contract, and my planned maximum loss is $300/butterfly contract, my backtesting shows me that my trade works and returns profit over a year's time. However, if market conditions have changed so that I routinely take profit at $125/$150 per butterfly contract and keep my maximum loss at $300/butterfly contract, the whole balance is destroyed.
That's a simple concept, right? Lower the planned maximum loss you'll allow before closing down a trade to keep profits and losses more closely matched.
Unfortunately, that's not as simple as it sounds. Let's look at my DEC RUT bearish butterfly hedged with a deep-in-the-money long call and some call debit spreads. Remember that my Options 101 articles are roughed out and the charts snapped well in advance of publication of the article. Prices are not current. Nor are profits and losses.
Live DEC RUT Butterfly Trade, at the End of the Third Day in the Trade, OptionNet Explorer Chart:
There's nothing wrong with this trade at this point. It's a 12-contract butterfly trade hedged to the upside. Delta is -18.06, so only -1.505 deltas per butterfly contract. However, the trade is down almost 2.86 percent, rounded to 3 percent on this snapshot. It's already required some adjustments, locking in a $299 loss in those adjustments. In addition, two-way commissions comprise $180 of the loss due to the way I've configured the profit-and-loss computation on the charting system. The other loss relates to changes in implied volatilities and other factors over the first few days of trading this trade. In all, that makes up a loss that is now $92.92 per butterfly contract.
An unrealized loss of about three percent during the trade is entirely normal for this trade and not alarming. Theta, or time-related decay, hadn't really kicked in yet since volatility changes have more than made up for any benefit from the short passage of time since I had initiated the trade. Although sometimes volatility changes benefit the trade right away and it's profitable from the first day on, allowing for a quick exit at full profit, this kind of behavior happens, too.
I have to count on my trade regularly being down $100-150/butterfly at some point during the trade, even when the trade is performing well. The price may still be inside the expiration tent as it was when this chart was snapped. There may be plenty of room left for profit potential, as is evidenced by the height of the expiration tent. I may still have many adjustment options open to me, and there may be plenty of time to allow that theta-related profit to come in. The trade may be working exactly as it's intended to work.
If I start setting my profit target at $125-150/butterfly contract so that I can quickly exit in more volatile market conditions, then I might be thinking about revamping my planned maximum loss to somewhere around $150/butterfly contract so that the target profits and max losses more closely match. That would mean that I would sometimes be forced to close down a trade that is still working, with the jury still out as to whether it will be a profitable trade or not.
That's the unintended consequence of taking quick profits. Trading friends commented on this conundrum with a different trade. Quick profits of 3-5 percent were often available only days after entry, but the traders also routinely saw unrealized losses at 3-5 percent only days after entry. They would have to cut that trade short and lock in that loss if they made a habit of taking those quick profits and rolled down the planned maximum losses to match. That might change the win/loss ratio of their trade, as it might do with my own.
What do you do if you think conditions are too volatile, and you're tempted to take quick profits when they're offered? Do you just keep the maximum loss where it was? If we're talking about a single month (or week, if you're trading weeklies) when there's something unusual going on in the markets or politically, you're not making a pattern of locking in smaller gains and it may not be necessary to do anything at all. Keeping that maximum loss where it was may be fine because you intend to go right back to your usual methodology.
What do you do if you find that, despite your best intentions, you're taking those smaller profits month after month? Keeping that maximum loss where it was is courting disaster, as one losing trade can wipe out the profits from many preceding winning trades. Now the trade setup must be retested, however, because the percentage of profitable versus losing trades might change once you change that maximum loss.
Rather than revamping your entire trade to control risk during volatile times, it might be a good idea to consider just cutting down the size of the trade. You can reduce the risk that way rather than fiddling with the planned target profit and planned maximum loss. If you want to keep the size where it is and plan to change the target profit and max loss, it's best to go back to the drawing board and test out the new profit target/max loss plan, to test whether the new setup is workable.
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