SMB’s Options Training Program Presents: The Heart Friendly Butterfly

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PART 4 HEART FRIENDLY BUTTERFLY: FLAT AND TRENDING MARKETS AND SCALING OUT FOR INCREASED PROFITS

Flat and Trending Months The examples in our previous sessions have been difficult months which have shown the full range of adjustments available to the heart friendly butterfly trader. But many months, the market will either simply channel, or trend in one direction to a mild degree, requiring neither whipsaw, nor extreme market adjustments as were demonstrated earlier. Often, in these types of months, target profit is hit at an early stage in the cycle in which case we may want to consider scaling out of the trade to “milk” it for more profits—while taking precautions to not risk too much of the target profit in the process.

January, 2010 Expiration

Upside and Downside Adjustment Points Established

Seven Days Later—Flat Market

No Adjustments Necessary for the First Full Week—a strong start

First Upside Adjustment

Flattens Deltas to the Upside

Market trending continues

But no further adjustment points hit

Happy New Year!

Target Profit is Reached

Scaling out of the trade At this point, the trader needs to decide whether to attempt to squeeze more profit out of the trade. This is a function of whether the upside potential is worth the downside risk of exposing some of the target profits to loss while trying to stretch the trade for further profit. If we decide to move forward, we’ll risk only 25% of the target profit on a two standard deviation move, in a quest to improve our return by 25%. We do this through a twice daily Two Standard Deviation analysis of the trade position—a very conservative posture. We don’t like giving up our target profits!

Can we prudently squeeze more profit from this trade?

Current trade not neutral enough

We begin to scale out of the trade

A two standard deviation move can now be tolerated.

Upside risk too high the next trading day at our 10:30 AM check

Upside Credit spreads reduced

Debit spread cuts upside risk

Profit slowly improving as we diligently stay on top of deltas

Upside at risk again

One more call credit spread bites the dust

Position now safer to the upside

25% improvement from profit target with minimal risk taken

Scaling Out Tips Sometimes it doesn’t work, but you give up, at most 25% of the profit target. You must be prepared for failures in this process. Often, the first step will be to cut down the lot size of the entire trade and then start “trimming” the high risk side of the trade. Another technique worth considering is pulling the wings in to the closest 25 point strike on both sides of the trade at the outside of the scaling out process. ALWAYS CHECK THE OTHER SIDE OF THE TRADE THAT YOU ARE NOT “FIXING”, SOMETIMES A FIX ON ONE SIDE CREATES A PROBLEM ON THE OTHER. If that’s the case, it is almost always time to exit the trade and cease the scaling out process.

The Scaling Out Process Scaling out of a trade is more of an art than a science. The more often you practice it in live trading, the better you will become and the more creative will be your choices. Done properly, scaling out can increase your annual returns and reduce your risk as you exit a trade.

CONCLUSION The Heart Friendly Butterfly technique allows a butterfly trade to breathe while “jumping” on delta problems through an active adjustment procedure. As a result, the trade is normally very much in control from a greeks standpoint and thus is a favored approach for traders seeking a reasonable annual return with much less stress than the typical positive theta options trade. Please backtest this strategy yourself, so that you can get familiar with it and clarify any concept that does not seem entirely clear to you, through practical simulation. Only then should you live trade the strategy, with minimal capital until you have some experience under your belt. Good luck and enjoy! Trading should be fun. It is for me .