As I've discussed in recent blogs, I've been using a three-legged spread to provide protection for my iron condor portfolio. No one has suggested a name for this type of trade, so I've decided to refer to it as a kite spread.
Example 1: The C3 Kite
Buy 1 XXX Mar 300 call
Sell 3 XXX Mar 320 call
Buy 3 XXX Mar 330 call
This is a call spread, so it's has the designation 'C'
The ratio is 1 x 3, and has the designation '3'
Example 2: The P4 Kite
Buy 1 ZZZ Jul 420 put
Sell 4 ZZZ Jul 390 puts
Buy 4 ZZZ Jul 380 puts
These are puts and the ratio is 1: 4. Thus, it's a P4 Kite.
Constructing the kite.
- Decide whether you are buying call or put protection
- Select strike price of option you want to buy
- Choose the spread to sell
- Decide how many spreads to sell
The number of spreads sold is determined so that the single long option is worth as much (or more) than the spreads are worth at their maximum value. In other words, if you sell four 10-point spreads, they can be worth $4,000. Thus the option bought is 40 points closer to the money than the long leg (the wing) of the spread.
In example 1 above, the 330 call is 30 points higher than the 300 call and the you sell three spreads (yes, you can always choose to sell fewer).
In example 2, the 420 put is 40 points from the 380s, and you can sell up to four spreads for each 420 put purchased.
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I think of the kite spread as a long option (call or put) that grows in value as the market moves. At the end of the kite there's a weight (the sold spreads) that can temporarily make it difficult for the kite to soar. But, if we catch a good wind, the kite can become more and more profitable.
516
Mark, could you post a profit/loss graph an example with an IC. Thanks
Ricardo,
Working on it. I’ll post later
That ZZZ stock seems an awful lot like BIDU
Hi Steven,
Coincidence. I don’t pay any attention to BIDU.
Regards,
So from what I can tell, you would do this to implement a “bullish/bearish within limits” strategy? To use put example, you have a bearish bias, but you have expectations on the limits of the bearish move (i.e. strong support level, etc). So you’re effectively using the spread premium collected to pay for your long leg, so you’re making the bearish bet “for free”. However, as both put and call versions are short vega, it seems the vega element is advantageous only on a call “kite”: falling IV will help the call/bull version but hurt the bear/put version. So the bull/call version could be more easily exited early for profit, while you would need the bear/put version to settle in the sweet spot near expiration. Do I understand this right?
1) I recommend implementing this srategy ONLY to provide protection for a position that loses money on a big market move. These include credit spreads, iron condors, covered calls or naked short puts.
I want to own an extra put or call – at a reasonable price (far from free). Obviousy that extra option works very well on a big move – and that’s when it’s most needed.
I would not make this trade as a stand alone play. That’s just me and my style. I do not buy options in an attempt to earn a profit. I only buy options as insurance against loss.
I earn my money by selling options (never naked) and buying insurance. The kite is merely one method of owning insurance.
2) There is nothing wrong with using the kite as a directional play. But as a non-directional trader, and as a non-option buyer, I don’t want to suggest that this is better than alternatives.
3) I think you understand this correctly, but when IV increases sufficiently on a decline, it’s easier to exit than you may imagine.
When the spreads become at the money, they will trade in the $5 range, regardless of IV (over a reasonable range) – but the extra put will already be nicely ITM, and have a pumped IV. To me, that suggests an exit that’s not too difficult. But I have not tried to exit.
If underlying declines farther, high IV keeps the spreads from increasing in value quickly, but long put grows quickly. Even better to exit.
BUT – and this i the big negative – if expiration is nigh, the credit spreads can quickly approach maxiumum value while the long option has ben hurt by time decay.
I noticed that these spreads always are profitabe in the initial stages of a move (puts or calls). But I do not close because I need the proetion. I may sell out the long leg and buy another, one strike away, to take cash out of the position.
Mark, I assume that the credit spreads that make up the initial iron condor that you are protecting are further OTM than the strikes used in the kite,true? How much further OTM are the IC spreads in the above kite examples? Thanks.
Jeff,
True.
When choosing strikes, there are two possibilities.
a) the IC options are not that far OTM and there is not much choice. This kite is going to cost more cash.
b) the IC options are far OTM, and you may choose from among many strikes.
Example:
You are short the 890/900 call spread.
a) If the underlying is 840 to 850, and if you want (preferred) a kite position without overlapping strike prices, you are forced to buy the 850C and sell the 870/880 call spread.
b) if the underlying is 820, then you have a choice that will depend on your goal. You can choose a kite with a good chance to earn a profit on a rally (lower strike prices, but more costly), or you just want protection (higher strike prices, less costly).
i) Buy 830 sell three 850/860 spreads or four 860/870 spreads.
ii) you can do a similar trade by buying the 840
iii) or you can get protection at a lower price by buying one 850 C and selling three 870/880 spreads. Same choice as in a) above, but being 30 point farther OTM than before, the price is less.
Flexible strategy.
Because this post is almost one month old, and I believe it’s important for more people to see this, I’ll repost it soon.