Think back to the afternoon of April 2. I'll set the scene.

April 2 was a Wednesday, two days before the important non-farms employment number. ADP numbers had come in that Wednesday morning right on target, hinting but certainly not promising that Friday's employment numbers might be on target, too. By late morning on April 2, SPX prices had punched to a new high, but then buyers hadn't been able to drive prices any higher. The RUT had pushed up just underneath a descending trendline off the 3/4 and 3/21 swing highs, but buyers of component stocks weren't pushing that index any higher, either. When the 3:00 pm ET turn was near, you were thinking of a speculative May IWM position, with 44 days left to expiration.

The IWM's action mimicked the RUT's, of course.

IWM Chart:

Which IWM trade would be better in these conditions?

IWM At-the-Money Butterfly with Extra Long Call to Hedge Delta:

IWM Strangle:

The financial commitment is similar for both trades: $671 for the at-the-money butterfly with the extra call to hedge deltas and $628 for the strangle. Deltas--the amount the trade will be helped or hurt by price movement--are similarly flat in both cases: -1.19 for the ATM butterfly and 2.35 for the strangle. Price movement won't hurt or help the trade much over a small movement, but will begin to matter if the price movement is big. However, it's clear from looking at the charts that you would prefer prices to remain in a tight range if you choose the butterfly and you would want prices to move far in one direction if you choose the strangle.

What's very different for these trades is the vega, the way the trade will react to a big change in implied volatilities. Vega is -16.01 for the butterfly trade and +59.58 for the strangle.

The first question traders choosing between strategies should ask themselves is whether they have any knowledge of the strategies and how they perform under different conditions. If they do not, the trades should not be entered unless a $600-700 investment represents only a small proportion of a trading account, the size that would typically be spent in speculative trades. Until traders learn how an options strategy behaves, a trade employing that strategy is a speculative trade, no matter if other traders might consider that particular strategy their go-to monthly income trade. For example, it's been years since I've traded straddles or strangles, so I currently would consider either of those only for the speculative portion of my portfolio although I've been trading fulltime for a long time now.

Traders should ask themselves whether they plan to adjust. If so, the trade's initial investment should be low enough that funds can be reserved for the adjustments. Adjustments cost money.

Once those questions are answered and out of the way, a trader can evaluate the pros and cons of each trade. Because of the differences in the vegas of these trades, they're going to respond differently to changes in implied volatility. We're accustomed to thinking about how trades might behave with changes in price. When deciding between these two trades, it's probably at least as important, if not more so, that traders have a view about what will happen with implied volatilities.

We know--or think we know--that even if prices move sideways for a day or two ahead of an important announcement, implied volatilities are likely rising. By two days before the important non-farm payrolls, that process has likely already begun. Then, unless prices roll over really hard after such an important announcement, implied volatilities are likely to collapse. Those who trade speculative trades around earnings announcements have learned to take this kind of process into account when planning trades.

However, is that same process always going on with options that are still 44 days away from expiration? You may have wondered why I was setting up a scenario in which you were asked to consider between strategies employing options 44 days away from expiration rather than in a closer expiration cycle. My intention all along was to present this question. Can we always expect implied vols to rise into an important announcement and then be crushed afterwards? Is that true for all expiration cycles, near and far out in the expiration cycle? I'm not Augen: I'm no expert in how implied volatilities behave in all situations, but I am a seasoned enough trader that I know you have to ask these questions.

OptionNet Explorer (ONE) tells me that the amalgamation of implied volatilities on the May options measured 16.98 percent late the afternoon of April 2. The day before, they had been 17.14 percent. Two days before, they had been 18.54 percent. A week before, 19.20 percent. Two weeks before, 17.28 percent. It doesn't appear that implied volatilities were rising for the options in the May expiration. Is our assumed truism about how implied volatilities behave headed into an important announcement always true for options further out in the expiration cycle? Maybe not. Can we be sure of a vol crush in that expiration cycle's options after the announcement? Also, maybe not.

The RSV, the RUT's Volatility Index, Chart Snapped April 2:

A Fibonacci bracket spans the RVX range from the November low to the February high. At the time the chart was snapped on April 2, the RVX was below the halfway mark of that range, in the lower half of the range over the last six months. Moreover, it was approaching 18 (percent, not dollars, as the Fib bracket indicates). That appears to be one level of potential support for the implied volatilities. The 17 percent level is another. Certainly, implied volatilities have dropped lower than that recently and they can again, but some traders like to think in terms of whether there's a greater risk that it will keep dropping or that it will rise again. The RVX had been in a chop zone roughly between 18 and 22, and that's about all that can be gleaned with certainty. I would likely have not have bet that the RVX would drop much below 17 before turning around.

If traders believe the RVX will likely soon rise, perhaps after a brief dip to 17 percent, is the butterfly the best speculative trade to consider among these two possible strategies? Perhaps not. Perhaps traders with this viewpoint would instead focus on the strangle as the speculative trade of choice. If so, is April 2 the best time to enter?

The possible dip to 17 percent in the RVX would fit with a small dip in implied volatilities after the upcoming Friday release of non-farm payrolls. The question, of course, is whether the May cycle would also see that dip. Still, there is one other point to make about that strangle. The price appears to be more expensive than two-contract strangles you've priced in recent cycles when options were about 44 days from expiration. Your best ideas of checking implied volatilities haven't uncovered a rise in implied volatilities as that important announcement loomed, but something is running that strangle price higher than normal.

You want the strangle based on your view that the implied volatilities are due for a bounce, perhaps after a brief dip, but it would be cheaper to buy the strangle after the implied volatilities drop, if they do. There's that possibility of at least a small dip in implied volatilities on Friday, based on your view of the RVX's possible support levels. The May cycle may indeed be impacted, based on your observation that the strangle price is running a little higher than you've observed in recent cycles. You decide to wait until Friday to enter.

What's the risk if traders had settled on this scenario and decided to wait? The risk was that something happened Friday morning before the open that would have made that trade profitable right away, and traders missed the opportunity to enter the trade and make that profit. The risk was that implied volatilities never dropped toward 17 after the announcement, for example, and there was never that opportunity to buy that strangle for a lower price.

That risk was realized. That last little RVX dip to 17 never occurred. On April 3, the IWM turned lower. On April 4, it plummeted with implied volatilities rising sharply. Near the end of the day on April 4, the sharp rise in implied volatilities and the sharp price drop had combined to produce a theoretical profit of $101 in that strangle priced on April 2, after two-way commissions. That was a 16 percent profit on the cost of the trade in two days' time, and the opportunity was lost for that profit.

Strangle on Friday, April 4:

By Monday, April 7, the strangle priced on April 2 would have collected a theoretical profit of $247 or 39 percent of the cost of the trade. Clearly, that would have been a missed opportunity if the trader had thought it possible that implied volatilities would drop after the non-farm payrolls and had passed up the opportunity on April 2.

But if this was a speculative trade anyway, isn't it okay to miss an opportunity rather than get into a bad trade? For example, the butterfly would have been down about one percent on Friday, and would have required adjustment, with both the strong price movement and the rise in implied volatilities hitting the trade.

Another trade will come along. That's one point of this article in addition to the invitation to think about how the considered strategies might perform under the then-current conditions. We go through our expectations for price movement and implied volatilities, and we make choices. All those choices have risks, including the risks of missed opportunities. All the charts snapped in this article were snapped real time as I was roughing out this article, with the April 2 charts snapped before I knew the outcomes on April 4 and April 7.

Of course, these trade possibilities have come and gone by the time this article appears. They were never meant to be trade suggestions, but rather served as another invitation to think about how potential trades might be evaluated. There are no guarantees, even if you go through such exercises before entering a trade. Yet, as you evaluate these trades beforehand, you will be able to evaluate what would make your trade go wrong and what you will do about it.

Linda Piazza