When discussing methods for protecting a portfolio from large losses, I've mentioned that I prefer a trade that allows me to own extra options – with the condition that those extra options are NOT father out of the money than my 'at risk' options. Those extra options offer the possibility of earning a good-sized profit if and when a truly unexpected major market move occurs.
The problem with buying extras is that the cost is high. When buying insurance, or adjusting a portfolio, one of the most difficult decisions is: How much should I pay? It's not the same situation as insuring a house against a destructive fire. If you cannot afford to replace that house from petty cash (as most people cannot), then insurance is needed, and the cost is not the primary concern. [We all know that we pay too much for insurance, or else the insurance companies would not be profitable]
When we trade with negative gamma (credit spreads, covered calls, iron condors, etc), at some point we may be called upon to make a risk management decision, and that decision will often cost cash. [Yes, we can always find a way to shift or roll a position for zero out of pocket cost, but that often increases risk, is not a good strategy for general use and is outside the scope of today's post]. There must be a spending limit when making a position safer to own. At some point, the investment becomes too large, profit potential too small, and it's best to exit the trade – accepting the loss.
Instead of buying extra options, an alternative is to buy spreads. These are far less costly than individual options, and they offer limited protection. I find that this is a winning trade-off under many market scenarios. Consider this method and decide whether it has merit for your trading.
When you buy a 10-point spread and pay $2, there is $8 worth of upside potential – if the market continues to move against your original position. That's a substantial amount of insurance at a very reasonable cost.
The problem is that these spreads are not available for $2. By the time the market has moved far enough to convince you that risk must be reduced, these spreads may cost $5 or more. In my opinion, paying half the maximum value of the spread is just too much to pay.
Here's an example:
You sold some call credit spreads: INDX Jan 920/930 when INDX was 840.
Now that INDX has moved to 890, the position is uncomfortable to hold (if it's not uncomfortable for you, at least assume it is for the basis of this discussion) and the experienced trader wants protection.
When buying debit spreads, the objective is to own spreads that are less far OTM than your current shorts because you must earn some good money from that 'protection' to partially offset the original position, which continues to lose money. I don't know how long you would hold out before buying protection, but let's assume that no one would want to stay in this trade when the short strike (920) is breached.
Figure 2, shows an adjustment: we bought 2 INDX Jan 900/910 call spreads @ $4 each.
The $800 paid for the trade comes right off the bottom line, if the market reverses direction. [Of course the trader always has the choice of selling out that protection when he/she feels it is no longer needed]
The $400 debit allows a gain of $600 for each spread, so the upside disaster is reduced by $1,200.
The good and bad news about buying call debit spreads for upside protection is that the expiration profit zone is much improved (red line vs blue line). It's good news because there is a nice area of significant profits. The bad news is that the trader may elect to hold this trade into settlement (Market opening for each stock in the index, on the 3rd Friday of the month), and that's a very risky situation. With the market in the best possible spot (between 910 and 920) at the close of business on Thursday, the trader is set up to take a big hit if the market opens somewhat higher on settlement Friday. A 10-point move is not that big for an index priced above 900 (it's a 1% move).
The protection looks good, but holding to expiration provides the same high theta (good) and large negative gamma (bad) threat – as always.
It's less expensive to buy the call spread with the highest strikes that are not already in your position (900/910 in this example). The advantage to that play is that you can buy more spreads for the same money as buying fewer, more costly spreads. I vote for the 900/910.
One variation is to buy more (or fewer) such spreads.
However, it's reasonable to buy an 890/900 or an 890/910 call spread instead.
Another choice is to pay even less and buy the 910/920 spread. In genral, traders shy away from this trade because it involves selling more of the option they are already short. There is no reason not to make this trade, unless it's difficult for you to examine your position and figure out exactly what you own. I recognize that this trade adds complexity to the position for less experienced traders. Note: I have no objection to this adjustment, but if you find it too strange to manage, then stay away. You can decide whether this specific adjustment type appeals to you once you gain more experience.
The last variation to consider is buying the 920/930 spread. Because that's the position sold earlier, this 'adjustment' is merely reducing position size. This truly is an overlooked trade. Those who refuse to take a loss, and feel they must adjust to allow an opportunity to escape a risky trade with a profit would never consider this trade. In my opinion, a trader should buy the call spread that seems to best serve his/her purposes. If that happens to be the trade sold earlier, then so be it. Don't let that stand in your way.
The idea of picking up some positve delta (or negative delta, when trading puts) in the form of debit spreads works as a good compromise when making adjustments for negative gamma positions. My philosophy remains the same on one important issue: Do not buy farther OTM options. When short the 920 call, as in our example, the adjustment (single option or spread) should involve purchasing a call with a strike of 920 or lower.
NOTE: A trader may choose to buy some very far OTM extras as ultimate protection. These are NOT satisfactory to protect a position such as a troubled iron condor, credit spread, or covered call. Recognize that this is a waste of money most of the time. But when the payoff comes, it's a dandy. Owning these options is not for everyone, but Nassim Taleb claims that it worked wonders for him.
Ideal Christmas gift for your friend who wants to learn about options