A Simplified Method for Buying Portfolio Insurance

I've recommended the idea of owning extra puts and calls as insurance against a major stock market move.  This insurance is only needed by traders who own positions with negative gamma, and who could otherwise be hurt by a big move.

There's no need to repeat the rationale behind this idea.  But if you discovered for yourself (or wish you had) how important this strategy is when the market either undergoes extreme volatility, or a steady, unidirectional move, then here's a simplified strategy you can use.

The trade begins with the sale of credit spreads.  These can be calls, put, or both (iron condor).  You can enter the order all at one time (recommended) or as two separate orders.

[I've been out of town for a week, and wrote several posts ahead of time.  Thus, I am making no attempt to use real prices because I have no idea where the market is today.]

1) Sell 3 credit spreads, for example RUT Sep 620/630.  Assume you collect $1.80 per spread, or $540.

2) Buy a naked call with a lower strike price.  Specifically, 3 strike prices lower than the call sold.  In this example, that's RUT Sep 600 call.  The cost is significantly higher than the $540 collected.  That means this is a debit spread and it costs money to own this position.  Although debits are not wonderful for premium sellers, it is part of the cost of doing business.  Insurance is not free.

This is a bullish play.  If the market declines, you will eventually lose the premium paid for the position (unless you accept the risk that comes with and selling your long call at some point).

If the market rises, you can never lose more than you invested (just as when you buy a call option outright).  You have two decent opportunities for profit (see below).

3) Optional:  Do the same type of play with puts, if you need downside insurance or want to make a bearish play.

4) Although I recommend not holding positions through expiration, it's much easier to talk about the result of this play by making the assumption that this is held all the way.  Obviously it's a good idea to exit the trade any time that you are satisfied with the profit or no longer need upside insurance.

a) IF RUT is between 600 and 620 at expiration,  the 600 call has value and you have a gain or loss, depending on how that value compares with the position cost.  Maximum credit you can collect (at this price level) for the position is $2,000. [At 620, the Sep 600 call is 20 points in the money and has an intrinsic value of $2,000]

b) Between 620 and 630, you begin to give back some of the profit at the rate of  $200 per point.  Why?  You are long one call and short 3 calls.  Being net short 2 calls, you lose $200 per point. [Because it is expiration, your long calls don't provide any help unless they become in the money]

c) At 630, your long call is 30 points in the money and is worth $3,000.  Your 3 short call spreads have reached their maximum value, and are also worth $3,000.  Your net loss is the cash you paid for the position, just as if all options expired worthless.

This is the reason behind buying the Sep 600 call.  You want the position to start accumulating value above the strike price of your long option.  If you don't use 10-point spreads, or if you chose a ratio other than 1 x 3, buy the appropriate call, instead of Sep 600.

d) Above 630, you earn $100 per point (as you would expect to do with any call option), with no upper limit.

NOTE:  If the long call is significantly in the money, it is going to be profitable to exit prior to expiration.  Why?  Two reasons:

1) Your long call still carries some time premium

2) The short spread has not yet reached it's maximum value of 10.

*** If you decide to exit the trade, don't pay $9.90 or $9.80 for the 10-point spread,  If you hold, you have a chance for a nice surprise, if the market tumbles and the spread declines in price.  Of course, there's a limit to how much to sacrifice.  For me, that 20 cents is about it.  For you?  Remember, not closing is gambling with some of your profit.

This is not perfect protection.  There are areas at which you have no benefit.  In exchange for that, you get to buy a well-struck (has a good strike price) call at a good price.

This is just another way to accumulate insurance.

ADDENDUM:  Later, I'll begin to describe this trade as a 'Kite Spread.'


10 Responses to A Simplified Method for Buying Portfolio Insurance

  1. Henrit 08/25/2009 at 9:33 AM #

    2) Buy a naked call with a lower strike price.
    A naked call, as a short call? Or as a single call?

  2. Mark Wolfinger 08/25/2009 at 10:04 AM #

    Buy the call, as a single call.
    Thus, using the example above, the position is
    long 1 RUT Sep 600 call
    Long 3 RUT Sep 630 calls
    Short 3 RUT Sep 620 calls
    I probably should NOT have used the word ‘naked’ which usually refers to a short position. But naked simply means ‘unhedged’ and a naked position can be long or short.

  3. RS 08/25/2009 at 10:37 AM #

    This position would then turn what was a negative gamma credit spread position into a positive gamma position when the underlying is still OTM from the naked long. It would change positive theta to negative theta as well, and the whole position would be very different from the original credit spread.
    If you use less hedge, you could still maintain a positive theta position. I use naked longs but right on the wings, which I find offer as much protection as closer to the money nakeds with the same cost (more naked options on wings) with one caveat – it loses power with less than 3 weeks prior to expiration – so I have to take that into account if I want to keep the position at that point.

  4. Mark Wolfinger 08/25/2009 at 12:11 PM #

    Hi RS,
    The fact that insurance is something that traders tend to hold, I decided that adding to the wings does not work for me – even when I close the position early. If you get good mileage out of doing that, great.
    Perhaps I was not clear in my explanation. The trade discussed in the blog post is not intended to be a standalone trade. It’s intended to be an additional position, on top of an existing iron condor. The purpose is to have a position that cuts into losses when the market makes a big move – plus the chance to earn some extra profit when the underlying is well-priced near expiration.
    Thus, it does not turn the whole position into negative theta and positive gamma. For example, I might buy the described spread 4 x 12 when I already own 25 iron condors. The amount of insurance that you, or anyone, buys is a comfort zone decision and there is no perfect quantity for everyone. in fact, most traders prefer zero insurance, but I’d rather reduce risk and thus, tend to always own some insurance.
    You and i have the same idea, but choose different strike prices to buy. No one is right or wrong.

  5. RS 08/25/2009 at 12:54 PM #

    I see what you’re saying – sorry I misunderstood. I have had (and still do have) closer to the money naked longs – all I do is purchase a ratio spread, selling some of the extra wings. And you’re right, there’s no right or wrong.
    Anyway, I’m always looking for different ideas of insurance for my ICs. I have a tougher time with a strong uptrend than I do with almost any type of down movement.
    Thanks for the blog.

  6. Mark Wolfinger 08/25/2009 at 1:16 PM #

    Thank you!
    I don’t like paying for insurance, but find it necessary.
    When I write about it, I try to offer lots of alternatives.

  7. Dave 08/25/2009 at 9:29 PM #

    I bought some RUT upside insurance today. I (think I) understand the various reasons why closer to the money is better… but purchased a few strikes up Sept OTM anyway, because; I’m guessing if we break out of this extremely major pivot bears will panic the indices into a large squeeze. I hate guessing directional scenarios and I’m curious if you consider ideas like that when writing an iron condor or do you play strictly by the numbers– always?

  8. Mark Wolfinger 08/26/2009 at 12:11 AM #

    I like to play ‘by the numbers’ when trading iron condors, but like anyone else, I become frightened by the possibilities. And I buy insurance. Right now, I am concerned that if this market stops rising (or comes to its senses) the decline may be huge. Thus, I am being careful to limit downside exposure. More bullish traders don’t have to do that. I also own upside protection.
    The problem is how much to buy and how long to hold it.
    It’s not that CTM is ‘better’ than OTM as insurance. But, if you plan to hold that insurance, as is likely [why buy insurance and then sell it out?], then time decay becomes important and if the market did not move by a large amount, those OTM options are no longer looking so useful – except as ultimate protection.
    That’s how I see it. If ultimate protection is what you need, then by all means, do buy those cheaper OTM options. So, it’s not ‘guessing’ direction – but if one side frightens you, it’s ok to buy a bit of extra insurance.

  9. Tom 08/30/2009 at 6:00 PM #

    Hello Mark and thanks for your excellent blog! I have been considering your thoughts on trading 2nd and 3rd month Iron Condors and did a successful test last month, closing out the position 1 month early. I have been trading front month RUT iron condors for an average credit of 1.00, however I tend to leg into my trades. For example, I will first sell the call spread as the market is rising for around 0.50 (based on some technical analysis) and then wait for an opportunity to sell the put spread for again around 0.50, or vice versa. On some months I do not open up both sides of the iron condor because I don’t like the risk of one particular side and can’t get enough of a credit that would give me sufficient “breathing room” in the trade.
    I had a question about your method of buying insurance. You tend to look for higher credits in your condors and then buy extra insurance. Would this not be similar to just opening up a wider iron condor for a smaller credit? It would seem to make things less complicated and have less commissions as well. I tend to think of these extra puts/call as complicating the overall portfolio, especially in relation to your recent posts on when you would then exit these positions (i.e. would you exit your long puts at the same time you adjust your put spread early?) I find the idea of opening up longer dated iron condors intriguing but the concept of purchasing extra insurance seems to really complicate the portfolio for me.

  10. Mark Wolfinger 08/30/2009 at 7:50 PM #

    I wrote a lengthy reply. Then decided to turn it into a separate post (so more people can see it).
    It will be published Sep 1, 2009, 5 am.