Portfolio Insurance

Mark,

You mentioned couple of times that you usually hold insurance against
black swan events. I would be interested to know what kind of insurance you carry – straight puts, spreads, expiration time etc. What
percentage of your portfolio per month do you spend on this insurance?

I
understand that there is no one right answer for this question, but I
would like you to share your view since I find myself agreeing with more
than 90% of your general trading philosophy.

Thanks a lot for your great blog!

Kim

***

Thanks Kim

I don't always hold insurance, and don't have any right now.  The truth is that it is very expensive when IV is elevated.  I manage risk by keeping position sizes a bit smaller and covering OTM spreads when they get to 15 or 20 cents.  This latter move may not seem to be much in the way of risk management, but:

  • When iron condor trading works well, it's like an income miracle.  There is no point in taking extra risk 
  • When this method doesn't work well and the markets are too violent, there is no point in taking extra risk
  • Thus, covering the far OTM, cheap call and put spreads makes sense to me

I own insurance more to protect my position than to profit in a black swan event.

My preferred insurance for protecting an iron condor portfolio involves owning extra options.  I prefer to own protection in the same month as the position being protected, but buying options that expire earlier do a much more effective job of providing protection.  They cost less and that means you can own strikes that are closer to being ATM.  The negative part of that play is that insurance expires before your position. [This idea is covered in detail in The Rookie's Guide to Options]

I have no problem with that because I like to exit my income spreads one month prior to expiration.  However, if you are like most traders and hold longer, it's not pleasant to lose your insurance, ad it will have to be replaced.

a) I want them to be less far OTM than the short options in my main position.  If short the 800/810 call spread, I prefer to own a small quantity of 780 or 790 calls.  Obviously these can get to be very expensive, so a big part of owning them is deciding when to buy.  Buy early when reasonably far OTM and they are cheaper.  Wait until they are needed, and they are more costly.  Of course, by waiting, you may never need to buy them, saving the cost. 

b) Black swan protection is good – if you are willing to spend the money.  I usually am not.  OTM puts are just very expensive, even when far OTM.  However, if you cannot afford the potential loss, it's worth every penny to spend a little money on real insurance.  Almost any puts are good for that – but be realistic when deciding how far OTM to go when buying puts.

c) When IV is low and options are cheap, I was willing to spend 20% of the premium collected on insurance.  Now, when IV is high, one gets very little protection for that cash.  I just don't buy protection when IV is as high as it is.

d) My preferred strategy for owning those extra long options is the kite spread.  That's a name I coined for a trade that looks like this (you can do the same thing on the call side):

Buy One Put

Sell three (or four) put spreads.
 
Strike of short is three (four) strikes below put bought

Pay a cash debit (these are not cheap)

Example:

Buy 2 INDX 700 puts
Sell 6 INDX (same month) 670/680 P spreads

or

Sell 8 INDX 660/670 P spreads

I like these positions because loss is limited to the debit paid for the position.  If you buy a put kite, the worst possible result is seeing all options expire worthless.  If the market declines, this position has value. 

The worst case occurs when expiration arrives INDX settles at the wing (the highest strike put in the kite).  At that point, the loss is limited to the cash paid for the position. 

The best case scenario is a gigantic move (down in this case).  Your credit spreads or iron condors may go to maximum value, but the naked long extras can earn far more than enough to compensate for all those losses.

e) Other trade ideas work, but with limited protection.  Buying call spreads and/or put spreads (less far OTM than your position being protected) costs far less and affords far less protection than buying naked options or kites.  But they do offer a decent chance to earn profits, depending on settlement price.

Kim, once you decide how much you can afford to spend, there are reasonable alternatives. 



An apology.  What a bomb.  I received zero entries for the crossword puzzle contest
I was trying to do something different, but will stick with what I do
best, and that's providing options education. If anyone cares, the
puzzle answer is below.

Puzzle_#1_answers 

767

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