In a previous post I commented on an article that went over adjustments of a butterfly. I was fairly critical of the approach taken, but I wanted to take the opportunity today to address the potential frequency of adjustments depending on the trigger.
Many traders probably find themselves wanting to make an adjustment just because the stock is moving toward their strikes, but it is important to know how probable an event like that will be. In Figure 1 you’ll see a P/L graph for a 113/119/126 May put butterfly on SPY for a debit of $2.38. The graph shows the potential range of profitability between 115.38 & 122.62 with the probability of finishing in that profitability range of 39%. We know from that data that the potential for making a profit is rather small, but the potential maximum gain of $3.62/share is much greater than the maximum loss of $2.38. The profile of this trade is that of lower probability and higher reward. However, those that make frequent adjustments are trying to make it a high reward and high probability trade, but how practical is that?
Let’s say that I planned to adjust this trade by rolling one of the verticals if the stock touched my break-even. In Figure 2 you’ll see the probability that each of the break-evens will be touched by expiration. The probability for the stock touching the lower break-even is approximately 68% and the probability of the upper break-even being touched is 53%. What this is implying is that the chance of having to make an adjustment is almost certain, and there isn’t an insignificant chance that both break-evens could be challenged and cause an adjustment to be made. In the end, it’s almost impossible to draw any conclusions from the initial probability of expiring number since the initial trade has little of standing as it approaches expiration.
Here is the point I’m trying to make with adjustments. I understand that some traders want to have a higher potential gain from the outset if things go according to plan, but are willing to sacrifice a part of that gain should the initial projection for the stock be wrong. That is certainly a reason for not entering the trade with a higher probability of success by skewing the butterfly. However, a simple adjustment based on the stock touching a certain price doesn’t necessarily allow for the stock to do what you want it to. It is the fact the probability of touching your break-even is much higher than the odds of it expiring beyond it that complicates things. Inevitably, most of those profitable opportunities would have been adjusted, the risk increased and the reward diminished. This makes it an important consideration to decrease the sensitivity of your trigger to make an adjustment.