Yesterday I blogged about why it's important for a trader to be flexible and be ready to change strategies (at least temporarily) when the market is not being kind to your current methods.
I also covered some ideas for protecting portfolios that contain negative gamma. Negative gamma causes positions to become more bullish as the market slides, and more bearish as it rises. Obviously that's not the path to profits when the markets are making significant moves.
Today let's look at a different idea for buying insurance to protect against large losses. This can be used as a standalone bullish strategy, or as as adjustment to an existing position. When one of your short spread positions is becoming uncomfortable to hold, it time to make a Stage I adjustment.
RUT, the Russell 2000 Index, is currently trading near 502 (2 hours before the close on 5/6/2009). Let's say you have an iron condor position in which you are short the Jun 530/540 call spread. The 530 call is more than 5% out of the money, but it has a 37 delta, and that's outside the comfort zone of many iron condor traders. whether you have already made an adjustment to your original position or not, this idea is applicable.
If you own a similar position and decide to buy protection against an upside loss, one obvious choice is to begin to buy back a portion of that spread to reduce exposure.
Here's an alternative:
Buy one Jun 530 call and sell three Jun 560/570 spreads. This trade gains 25 delta for each 1 x 3 unit. At current prices it costs about $1,100 in cash. That's a costly adjustment, but it's roughly the same cost as buying three Jun 530/540 spreads; and I'd rather spend a few extra dollars to make this trade.
Are you worried about buying one call and selling three spreads? Don't be. The fact that you gain one call option each time you make this trade enhances your upside. If RUT moves over 570, the three spreads will be worth $3,000 at expiration. But the 530 call will be at least 40 points ITM, and thus worth at least $4,000. This trade cannot add to your upside woes, and makes sense for some traders. If this trade is attractive, you can use it as a separate position.
This type of trade is flexible and you can sell a different call spread or use a different ratio. But be careful: If you want to reduce cost and thus, sell too many spreads, then upside profits are no longer unlimited (at least over a reasonable price range).
Buying a call you are short, instead of buying a short spread, provides interesting upside possibilities for a portfolio that faces upside risk.
The equivalent trades can be made with puts.