For butterfly traders like myself, there are scenarios that occur where a trade can appreciate very quickly. This can happen for several reasons. One of the very common causes of this phenomenon is when the trade is initiated in a high volatility environment and then the volatility is removed from the market rapidly. In other cases the market simply channels for the first week or so of the trade, and with a little bit of help from a drop in implied volatilities, it is not uncommon for a butterfly trade to appreciate 10-18% in the first 7-14 days, of a 30-35 day trade.
In these scenarios, it is important not to get greedy. The market has given you a gift–it is wise, in most cases to take it. While you can’t expect this to happen more than 3-4 times per year, it is important to recognize that you are in such a scenario and handle it properly. Depending upon a trader’s personality, there are a number of things that can be done at this juncture:
1. You can simply exit the trade. This is an excellent idea, particularly if some event is coming up–an FMOC meeting, a jobs report, or if the butterfly involves a single stock, an earnings event or some other important announcement.
2. You can reduce your lot size on the trade.–This is an excellent way to cut deltas and keep some of your “bet” up on the table, while removing a meaningful portion of your win from risk. My personal favorite method in this regard is to cut as many lots as necessary to assure that a one day, two standard deviation move (in either direction, INCLUDING consideration of implied volatility movement) would create no more than a 25% loss of the peak level of profit that the trade has achieved to date.
3. You can remove portions of the trade creating the most delta risk to the already excellent profit that you have attained in a very short period of time. In fact, in a double butterfly situation, the butterfly farthest from the money may have in fact turned negative theta, and, therefore, by reducing or eliminating it, deltas are cut AND theta is increased. Sweet.
The point is that when the market gives you a gift, to sit there and assume it will be available to you forever, is usually foolish. It is better to either take the trade off completely, or at the very least take some of your profits off the table and very carefully monitor that you do not give back much of that profit in the legitimate exercise of trying to judiciously squeeze more out of trade.
Seth Freudberg
Director, SMB Options Training Program
The SMB Options Training Program is a program designed for novice and intermediate level options traders who are seeking an intensive training process to learn how to trade options spreads for monthly income. For more information on this program contact Seth Freudberg: [email protected].
