I've been discussing the kite spread, suggesting that its primary function for option traders is to provide protection for an iron condor (or credit spread) position.

It's time to answer a simple question:

Why bother using a kite spread, when you can buy a call or put to protect the portfolio?

Definition of kite spread: A three-legged option position consisting of

• The string: One long call or put option

How many credit spreads are sold?

The wing option (farther OTM) is X strikes farther OTM than the string option.  X = number of credit spreads.

Example:

Buy one SPX Oct 1150 call

Sell 3 SPX Oct 1200/1225 call spreads

Notice that 1225 is three 25-point strikes away from the string (1150 call), and thus, three spreads are sold)

The function of insurance is to earn a profit to offset, or partially offset, losses that result from another position.  Those other positions are typically credit spreads (including iron condors).

Thus, the 'insurance position' must show a decent profit on a significant up or down move.  The 'obvious' solution is to buy calls and/or puts.

But the kite is often a better choice and offers more versatility.

Let's compare the purchase of a 60-day call option with the purchase of a 60-day kite.  Today, I want to make two points.

The P/L graph shows the differences.

Kite in Blue

Call in Red

Thick lines represent the position at expiration.

Thin lines represent the P/L on analysis date (in Figure one, that's 60 days prior to expiration)

Figure 1

Graph compares two insurance policies of approximately equal cost.

Kite:  The 60-day SPX 1150 C3 kite (for nomenclature)

Call:  The 60-day SPX 1200 call

Point One:  On a major move, the call earns a larger profit.  Specifically \$2,500 more in this example.  ['Kite call' is always worth \$5,000 more because its strike is 50 points lower.  However, after subtracting the value of the sail (3 spreads at \$2,500 each), and the whole kite is worth \$2,500 less than the naked long call – when underlying is above 1275 (the wing).

On a quick move higher, the call also outperforms the kite (compare thinner lines).

Point Two: The kite affords the possibility of a decent profit – and thus, provides better protection – over a wider range of SPX prices (at expiration).  I don't recommend holding positions until they expire, but I know that many traders do hold that long.

How well either insurance 'policy' protects the portfolio depends on how rapidly the position being protected is losing money.  That affects the strike prices chosen for your insurance position, but it does not affect which strategy works better for your individual comfort zone.

Have you reached a conclusion on kite vs. call?  There's more to consider.

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1. Fabiano 12/09/2009 at 7:48 AM #

Hi Mark,
Which option do you preffer?
1) Buy the insurance (Call and Put) when open the Iron Condor?
Will be cheaper but you spend this money on every trade.
2) Buy the insurance when RUT reach a pre-determined point?
3) Buy the insurance when the overall portfolio reach X% Loss (not realized loss), Like 15%,20%,25% of the maximum profit of the portfolio?
4) Buy the insurance when one of the IC reach X% Loss? Will be really hard to manage 5-10 different Iron condors in separate, right?
To use the pre-insurance when you open the IC with 75-90 days left you have the risk that it will be useless if you need it only on the last 30-45 days of the IC, right?
Thank you
Fabiano.

2. Mark Wolfinger 12/09/2009 at 8:13 AM #

Hello Fabiano,
There is no ‘best’ time to buy insurance. It is one of the difficult decisions. No one wants to ‘waste’ money, but taking too much risk is not so good either.
This topic is important and I want to respond at length. Look for the reply Friday morning, Dec 11, 2009.

3. Don 12/09/2009 at 6:24 PM #

Hi Mark…I love the idea of insurance and Fabiano asks some very good questions. I am looking forward to Friday’s discussion- perhaps you can address this question-
When I set up an analysis in TOS software it seems that I simply cannot avoid (if I purchase a single put and single call as dictated by the Kite strategy) paying out money. With RUT at 600 if I had a 3x3x1 540/550 650/660 while purchasing the 580 Put and the 620 Call for the same expiration dates I am at a cost and can’t find a credit.
Is this correct? Am I structuring everything correctly? Of is this just the cost associated with insuring the IC?
THanks

4. Mark Wolfinger 12/09/2009 at 8:18 PM #

The difference is:
a) With the kite you buy ‘better’ (closer to the money) options.
b) The kite can be held longer without suffering as much time decay. This is important because the plan is to hold – for as long as you hold the iron condor it is protecting.
c) If the underlying moves far beyond the strikes, both provide good profits – but the kite’s profit is LESS.
The kite is not ‘so much better’ that you ‘must’ use it. I like the advantages of using the kite. They outweigh disadvantages – as far as my comfort zone is concerned.
The kite spread is versatile and there is much to discuss. It’s going to take some time.

5. Brian 12/10/2009 at 7:18 AM #

Hi Mark,
Thanks for the posts,they are very helpful. Just a question about when opening the Kite insurance.If for example you open an iron condor with 60 days to go and the shorts are 70 points out of the money, after a week – 10 days RUT has moved 20/30 points towards one of your short strikes and it therefore gives very limited choices of where to open the kite spread.
My question is, is the best time to put the Kite spread on when you open the iron condor and therefore giving a wider choice or range of strikes to choose from?
Thanks
Brian

6. Mark Wolfinger 12/10/2009 at 8:01 AM #

I’ve written about this previously. In fact it was in Part I of this two part post.
1) If you wait until insurance is needed (and that is a very acceptable decision), then yes , you have one one (perhaps two choices) for a kite that does not overlap the original credit spread that you are protecting.
2) You do have the alternative of selling more of the spread already short, and buying the appropriate string option.
3) Yes, opening the kite early affords more choices – and I showed you the advantage of each choice: one for better profit potential (at higher cost) or one that affords good protection at a lower price. Or one in between these alternatives.
4) The decision of when to insure must NOT be based an kite alternatives. It must be based on your style. Do you want insurance now, or do you prefer to wait until a first stage adjustment is needed?
Or do you wait until the short spread is already ATM? If you do that, you will find kites to be very costly and no longer your best choice.
PLEASE UNDERSTAND: I like the kite. But I do not like it enough to tell you to go out and buy them, sacrificing your risk management plans. Adjust when YOU believe it’s the right time to do so.
The kite is one alternative among many.
As an aside, I like the kite for more reasons than its ability to act as an insurance policy. But I don’t want to dump all that information without a full explanation of each. Thus, it’s going to take time.
In addition, there are other topics to write about, so I may move on to something else and abandon the kite spread for a time.
However, I am working on a full-length book on the topic and will finish as quickly as I can.