Sometimes traders want adjustments that reduce risk or margin rather than add to it. Last week, I noted some possible situations or adjustments that might employ this tactic. I thought the topic might deserve a couple of illustrative graphs, especially for those who are relatively new to trading complex positions.
Sometimes I illustrate particular situations with snapshots of my live trade, but subscribers trade all kinds of trades. This time, let's start with a simulated 4-contract iron butterfly on the RUT, established at the following strikes: +4 NOV 1160 calls/-4 NOV 1110 calls/-4 NOV 1110 puts/+4 NOV 1060 puts. Because ATM butterflies always start out with negative deltas, some traders routinely buy an extra call or call debit spreads. (Note for newbies: negative deltas mean that the profit-and-loss line slopes down too quickly on the upside, making the trade get into trouble faster with a gain than with a decline.) I added an extra NOV 1160 call to this fly setup because it halved the negative deltas and smoothed out that PnL line.
Theoretical Iron Butterfly Setup:
The margin in this trade would be $6,775.50. The value can be eyeballed on this chart or calculated, but the OptionNET Explorer platform on which this is shown also calculates that value. Publication width restrictions didn't leave room to display all the values returned.
By Tuesday, October 28, six days after trade entry, the RUT price was approaching the upside expiration breakeven. Most traders would have decided that the trade needed some attention, an adjustment.
Theoretical Values on October 28:
Traders adjust differently. Many butterfly traders expect to adjust a butterfly sometime during the trade because the expiration breakevens are narrower than a one-standard deviation move away from the price at the beginning of the trade. It's likely that the price is going to move outside the boundaries sometime between the beginning of the trade and expiration. For that reason, most butterfly traders elect to hold back some of the money they intend to spend on the trade, not using up all the funds they intend to devote to the trade when the trade is first entered. These traders reason that they'll spend more money when making adjustments, even if their adjustment plans are to move the current number of butterflies. Some traders, however, plan to add more butterflies when the expiration breakeven is approached and that's going require even more funds devoted to the trade.
Adding More Butterflies, Adding More Margin:
The blue expiration graph and PnL line pertain to the original position, while the green versions show what would happen if 4 iron butterflies centered at 1140 are added to the position. That addition raises the upside breakeven from just above 1143 to nearly 1158. The addition flattens the PnL line, too, so that the maximum planned loss isn't reached quite as quickly, although the adjustment might have been even more effective if the extra butterflies were added just a bit sooner.
As the green expiration graph shows, the tactic dramatically increased margin. Margin was raised from $6,777.50 to $14,147.50. Yikes. What if the trader hadn't planned this type of adjustment in advance and had no intention of risking more than $14,000 on this trade, this month?
An adjustment that lowered the margin might be chosen instead.
Rolling Flies Higher, Reducing Number of Flies, Rolling Long Call Higher:
Closeup of Strikes Chosen to Roll the Flies and the Extra Call Shown in Green:
Rolling into a 3-contract iron butterfly at higher strikes and rolling the extra long call resulted in this position. The sidebar to the left of the expiration shape shows the original strikes in blue and the strikes chosen to adjust the trade in green. This action locked in some realized losses, added in some significant extra commissions and reduced the maximum profit available, but it smoothed out the PnL line while reducing the margin. There's still plenty of room for potential profit.
Is this the best adjustment? That depends on market conditions and many other factors at the time the adjustment is needed. The point was to illustrate that it may be possible to construct adjustments that give the trader a choice between adding to the margin in a trade and reducing the margin in a trade. The choice that's made may be driven by market conditions, the length of time in the trade, the size of a trader's account, how risk-averse that trader may be, and the trader's outlook. A trader might not be too nervous about the risk of a 15-percent loss on a $6,777.50 trade, but undone by the possibility of a 15-percent loss on a $14,000 one.
The choice could also depend on the trader's outlook on the markets, although I try to just trade what I see, not what I believe will happen next.