I skipped the April cycle in my monthly butterfly trade. Should I have?

The argument can be made that we can't predict in advance how markets will behave, no matter how many technical analysis tools we employ. The cycle you fear may turn out to be one in which your trade comes to quick profit with few adjustments. If we've adequately backtested our trade through all types of market movements over a long-enough period of time, and the trade works over the long run, maybe it's not such a good idea to skip a cycle and potentially miss an opportunity for profit?

It wasn't my intention to skip the April cycle. Despite having just come out of a particularly difficult March cycle, as described in my March 14 article, I planned to put on my April trade at my current preferred entry period.

A few days before the planned entry time, I set up the trade on a simulator and watched the costs of the trade. Since I employ a complex trade composed of several parts (bearish butterfly, deep-in-the-money call, Armageddon put, and call debit spreads, as needed), I mostly watch the total cost for the complete trade. I do, however, also watch the costs of put butterflies about twenty points below the current price. My butterfly orders go in first as I begin opening a trade, so I wanted to have some sense of what a good price for the butterflies would be in the then-current conditions. In addition, I watch the spread book on my trading platform in order to determine, if I can, which orders are getting filled and which aren't. I watch volume. Is there adequate liquidity to get easy fills? If I have time, I hang around on chat groups such as the live chats available through think-or-swim to listen to chatter about how fills are going.

I had done all that. Then the preferred entry time had come. The theoretical overall price for the complex trade was good, and the butterflies themselves were priced well according to what I had been seeing for the previous few days. In went my order at the mark or mid-price between the bid and the ask for the butterflies.

That order didn't fill. I'm patient, I still had several days left within my trade-entry window, and I had reason to wait for fills at good prices. I didn't like the market behavior. I didn't want to start off at a disadvantage by paying too much for my butterflies. After enough time had passed, I upped my offer, but I was willing to move only $0.20 away from the mid price or mark. No fills.

The next day, I tried again. Same result. My order didn't fill, and, moreover, the RUT was becoming more volatile. That volatility constituted another reason I didn't want a bad fill. Experience had taught me that if I was having difficulty filling my butterfly orders, I would also likely have difficulty filling the orders for the call debit spreads that would be the last orders I filled. When completed, my trade this year typically includes 15 contracts of butterflies and often, in the beginning, about six contracts of call debit spreads in addition to easier-to-fill single options that were also part of the trade. Paying $0.20 too much on a single butterfly or call debit spread contract translates into paying only $20.00 too much ($0.20/contract x 1 contract x 100 multiplier = $20.00). However, paying $0.20 too much on all those contracts translates into $0.20/contract x (15 butterfly + 6 call debit) contracts x 100 multiplier = $420.00. Add to that the considerable commissions, and I didn't want to be any deeper in the hole than that when opening my trade. I wasn't going to pay $0.25 or $0.30 over the mid, I decided.

That pattern continued for a few days. It was getting late into my preferred entry window, and I decided to skip that cycle. Should I have? I didn't enter live, but I did track a simulated trade as if I had entered it. I built in a price $0.30/contract more than the mid for both the butterflies and the call debit spreads.

Expiration Graph for Simulated Trade at Entry:

OptionNET Explorer, the graphing program used above, allows me to input my commissions both ways, for entering and exiting the position, so those commissions contribute to the immediate unrealized loss of $815.00! Whew, that trade had a lot working against it, and you can see why I was hesitant to enter with disadvantageous pricing combined with dicey market behavior.

That trade might have started out with a lot against it, but thirteen days into the trade, the profit was within my $250-300/butterfly contract profit target. All I'd done during those days in the simulated trade had been to add and subtract call debit spreads several times during the course of the trade when the delta grew either too positive or too negative for my liking. Unlike the previous two cycles (or the one I'm trading live as I write this), there had been no need to move butterflies when price went too far one direction or the other. Price had stayed within the butterflies' expiration breakevens the whole time. That doesn't happen often!

Simulated April Trade with Built-in Slippage at Opening, Now 13 Days in Trade:

Of course, I likely would have encountered slippage exiting the trade, just as I most certainly would have entering the trade, but the profit was well above $250.00/butterfly contract, and I could have accepted some slippage.

It's important that I collect those profits to balance against the losses that occur some months. My backtesting showed me that I could make a profit over a long period of time if I was trading month after month, even during downturns. Does that mean that you should always enter your trade month after month, or week after week if you're a weekly trader, no matter the market conditions?

After all this buildup, perhaps I'm going to surprise you. I still believe the answer is no, not in all cases. This butterfly trade offers lots of potential profit. It can recover from a blow such as a bad entry or the need to add call debit spreads one afternoon and take them off at a loss the very next afternoon, only to have to add them back in the next day when prices gyrate for a few days. A monthly iron condor, on the other hand, has a much more limited profit potential, and it's much harder to recover from slippage from a bad entry. Weekly trades have little time to recover from adverse price action, even if the trade itself has plenty of profit potential, and some market conditions just may be blatantly wrong for such a trade. I've seen many a butterfly that was working well fall apart when carried too close to expiration, for example.

Know your trade and the way changing market conditions impact that trade before you decide that you should enter your trade on schedule, no matter what. Let your backtesting inform your decisions. On the Couch Potato part of the site, Dot Hazlin sets up parameters for some trades that exclude an entry if the underlying has moved more than a standard deviation that day, for example. Her backtesting has shown that some weekly trades should not be entered if the underlying is too volatile.

My own testing has shown me that the type of trade I employ tends to profit over a year's time, no matter the conditions as long as I manage my losses and keep them to the $300-350/contract that I've set as my maximum loss. However, it's also shown me that there's one kind of setup in which it's almost impossible for that trade to profit or, at least, for me to bring it to profit. That occurs with an entry just after there's been a steep price drop accompanied by a sharp rise in implied volatilities such as the one we saw into February's low. The common assumption is that it's better to buy a vega-positive strategy such as a butterfly (or iron condor) when implied volatilities are higher because they're cheaper, but it wasn't the price of the butterflies that proved problematic when I backtested such trades or have gone through them in live trading. The extent of the relief rallies when they came, often necessitating moving butterflies, and the continued price volatility that often makes that expensive adjustment problematic very soon made it difficult to bring that trade to profit. All those after-the-debacle price swings are often accompanied by big swings in implied volatilities, too. Because price is thrashing around, there's no sitting in a single place while theta-related decay occurs.

I ran such trades through simulators over and over without much improving the results. For me, my backtesting showed that over a year's time, my trade is likely going to return a profit but it almost never is if the entry time is immediately after a sharp drop such as February's or, I imagine, like the one we just had. When I get through wrangling my open live trade this cycle, I will probably be wary of entering a new cycle unless the RUT has already worked off a few of its wildest swings through relief rallies. I believe in entering trades month after month according to a backtested plan, but when your backtested plan shows that one type of setup is almost never going to be profitable, I'm going to be wary of that particular setup and I'm certainly not going to pay too much for the privilege of entering a trade.

In addition, no matter what one's plan shows, I would never advise anyone to enter a trade if they're scared to do so. Scared traders are emotional traders, and it's hard to stick to the trading plan. I would never advise them to enter a trade because someone else's trading plan says it's okay to enter month after month, no matter the market conditions. If it's someone else's testing that has intrigued you, you won't have the confidence in the trade that you would have if you've tested it yourself. That, too, turns you into an emotional trader when the trade goes wrong.

In general, if your backtesting or long-term small-size live testing in various conditions has convinced you that entering routinely, at a certain time or under certain conditions, returns a profit over the long run, enter when it's time to enter. You likely weren't paying attention to the economic calendar, Russia's standoff with another country or concerns about China's growth when you backtested the trade. If your plan tested well, you shouldn't worry unduly about them when entering live trades month after month, although you might want to exercise a little caution about the exact timing of the entry. Weekly trades are another matter since they have so little time to recover from an adverse reaction to a planned economic release.

However, if there's a particular setup within that plan that's shown consistently that it's going to produce a loss, it would be a bit illogical to just plow into your trade willy nilly when that setup presents itself again. Also, if something has changed in your life--such as a life event, illness or something else that makes you more susceptible to emotional trading--your plan has changed. Your plan included the assumption that you could follow the plan without undue emotion!

Linda Piazza