Read Part 1 – The Basics
Read Part 2 – How To Set Profit Targets and Stop Losses
Read Part 3 – How To Successfully Leg Into A Butterfly
Read Part 4 – Trading Rules
Read Part 5 – Using Low Risk Directional Butterflies
Read Part 6 – The Greeks
Read Part 7 – Broken Wing Butterflies – One-Size Fits All
Read Part 8 – The Reverse Butterfly
Read Part 9 – Using Butterflies In A Combination Or As A Hedge
Read Part 10 – How To Protect Against Fast Moves
Read Part 11 – The Bearish Butterfly
The ability to adjust trades is what sets great traders apart from average traders. Some traders may prefer not to adjust and just stick to the standard profit target and stop loss. Adjusting can allow you to turn a losing trade into a profitable trade, but it does involve risk and can make your trade more complicated. More traders blow up their accounts through bad adjustments than through bad trade initiation, so keep that in mind.
When it comes to adjusting butterfly spreads, there are plenty of ways to go about it and I will introduce some of the more common methods.
For a neutral butterfly, some traders like to adjust once the breakeven point on the profit graph has been exceeded. As mentioned previously, if you want to be a little more cautious, you can adjust when the price moves into the outer third of the profit tent. The other method is to adjust the trade when losses hit 6-7%. Either method is fine, but keep in mind that when you adjust from a losing position, you will either decrease your profit potential or increase your risk.
For any trading strategy, it is a good idea to have at least 6 months of experience in a variety of market environments before allocating a significant amount of capital to the strategy.
One method of adjusting a butterfly is to add a second butterfly once the breakeven point on the profit graph is reached. The advantage of this is that it gives you a new profit zone near where the stock is currently trading and gives you a nice wide profit zone for the stock to land in. The disadvantage is that you are allocating more capital to the trade. Generally it is not a good idea to continue throwing more capital at a losing trade.
Here’s how it works.
On August 12th, 2013 with RUT trading around 1050, you enter a September 1030-1050-1070 call butterfly spread. Four days later RUT is trading at 1030 and you need to adjust.
Date: August 12th 2013
Current Price: $1050
Trade Details: RUT Call Butterfly Spread
Buy 5 RUT Sept 19th $1030 call @ $36.40
Sell 10 RUT Sept 19th $1050 calls @ $23.35
Buy 5 RUT Sept 19th $1070 call @ $12.95
Premium: $1,325 Net Debit
On August 16th, with RUT trading at 1030, we add a second butterfly centered at 1030
Date: August 16th 2013
Current Price: $1030
Trade Details: Second RUT Call Butterfly Spread
Buy 5 RUT Sept 19th $1010 call @ $31.95
Sell 10 RUT Sept 19th $1030 calls @ $19.40
Buy 5 RUT Sept 19th $1050 call @ $10.15
Premium: $1,650 Net Debit
By making the adjustment we have added another $1,650 in risk capital to the trade, and in effect created a profit diagram that looks like a mini iron condor. The new position looks like this:
Long 5 RUT Sept 19th 1010 calls
Short 5 RUT Sept 19th 1030 calls
Short 5 RUT Sept 19th 1050 calls
Long 5 RUT Sept 19th 1070 calls
Total Capital at Risk: $2,975
Maximum Profit: $7,025
With RUT at 1030, you don’t have a lot of room to move on the downside with the breakeven point being around 1015. Theoretically, if RUT continues down you can add a third butterfly, but this is again going to increase capital at risk and decrease potential profits.
Here are the Greeks before and after the adjustment:
Another adjustment you might choose to make is adding call credit spreads. You can do this in a couple of ways. Using the example above, with RUT at 1030 we could sell some additional 1050-1070 credit spreads to turn the trade into something that looks like a Broken Wing Butterfly. You could call it that, or you could call it a Credit Spread With Protection. Either way, this is how you do it.
Date: August 16th 2013
Current Price: $1030
Trade Details: Adding Call Credit Spreads
Sell 5 RUT Sept 19th $1050 calls @ $10.15
Buy 5 RUT Sept 19th $1070 call @ $4.60
Premium: $2,775 Net Credit
We are bringing a large credit in for this trade, meaning the total net credit received is now $1,450. The disadvantage is that we have significantly increased our capital at risk when compared with the previous adjustment of adding another butterfly. We now have $8,400 at risk in the trade as opposed to $2,975 in the previous example.
The other potential pitfall with this adjustment strategy is that you now have a significantly short delta. That may be ok if your market opinion has changed and you think the market is entering a new downtrend. But you may not want to take such a strong directional exposure. Here is how the greeks compare:
As you can see, you now have a very short Delta at -65. Delta is also higher than Theta whereas before the adjustment it was one third of Theta. The iron condor adjustment gave you a delta neutral position.
If you like the look of the Broken Wing Butterfly adjustment, but are concerned about the delta exposure, there is a way to cut delta without adding any extra risk capital to the trade. We do that by adding some put credit spreads. Here’s how:
Date: August 16th 2013
Current Price: $1030
Trade Details: Adding Put Credit Spreads to Reduce Delta
Sell 5 RUT Sept 19th $980 puts @ $7.70
Buy 5 RUT Sept 19th $960 puts @ $4.90
Premium: $1,400 Net Credit
Your profit diagram at expiry now looks like this:
This extra piece of the adjustment has the added benefit of bringing in more income, while not tying up any extra margin or capital. We have now received a total net credit of $2,850 and our delta has been cut to -30.
With this last adjustment you should keep in mind that you now have a pretty complex position that is going to be difficult to adjust if the trade gets into further trouble. You want to weigh whether it is worth making this adjustment, or if it’s better to just take your losses and close the trade. The other disadvantage of this adjustment is the number of trades you are making is increasing, so you are incurring more commission costs and more slippage through the bid/ask spreads.
Adjusting Profitable Trades – The Reverse Harvey
The Reverse Harvey is an adjustment strategy developed by Mark Sebastian and Dan Harvey. The idea behind the adjustment is that you want to lock in profits on a winning trade. With successful butterfly trades, once time passes, the sensitivity to movements in price increases. In other words, the slope of the current risk graph becomes more pronounced.
If the stock makes a large move, your profits can quickly disintegrate. Due to higher levels of short gamma the closer you get to expiry, your P&L will fluctuate more wildly.
You can see this in the 2 diagrams below. With the stock right at the short strike, a move of 30 points would result in a decrease in profit of roughly $1,500 for a trade with 40 days to expiry and $8,500 for a trade with 10 days to expiry, quite a significant difference!
Profitable Butterfly With 40 Days To Expiry
Profitable Butterfly With 10 Days To Expiry
The increase slope is caused by increased gamma as you approach expiry and the fact that the wings provide less protection. If the stock is right at the short strikes and there is not much time to expiry, the time premium of the outer wings will have almost evaporated and no longer provide much of a hedge. For this reason it makes sense to “tighten the noose” in order to protect profits as time passes. This is where the Reverse Harvey comes in.
The Reverse Harvey involves selling the outer wings and bringing them in closer to the short strikes. This provides more of a hedge for the short at-the-money options and reduces the overall short gamma of the trade. As a result the profit graph becomes more smoothed out again.
To watch the video by Mark Sebastian on the Reverse Harvey, visit this link. The example given in the video by Mark is this:
Date: Jan 4th 2011,
Current Price: $1274
Trade Details: SPX Iron Butterfly
Buy 10 SPX Jan 21st $1235 puts
Sell 10 SPX Jan 21st $1270 puts
Sell 10 SPX Jan 21st $1270 calls
Buy 10 SPX Jan 21st $1305 calls
After 3 days the trade is showing a decent profit, so Mark brings the wings in 10 points.
Date: Jan 7th 2011,
Current Price: $1275
Trade Details: Reverse Harvey Adjustment
Sell to close 10 SPX Jan 21st $1235 puts
Buy to open 10 SPX Jan 21st $1245 puts
Sell to close 10 SPX Jan 21st $1305 calls
Buy to open 10 SPX Jan 21st $1295 calls
This is the adjusted risk graph. The pink line is the adjusted position and the red line is the original position. You can see that the risk graph as of today (dotted line) is much smoother after the adjustment and the other added benefit is the capital at risk is greatly reduced. Mark suggests performing a Reverse Harvey adjustment once you are up about 5% on an Index butterfly.