Buying Extra Puts as Insurance II

Recently I discussed the idea of owning a few extra calls and puts when your main strategy is buying iron condors.  The idea behind that method is to protect yourself against substantial losses when the market makes a sustained move in one direction.  As we have seen recently, the market can make such a sustained move in a single day! (INDU was down 777 and the next day up 485.  That occurred this week.)

The problem with buying extra options when IV is as high as it is right now – (VIX* = 45; RVX** = 49) – is that those extra options are expensive.

* VIX = CBOE volatility index and is based on S&P 500 Index options
**RVX is based on RUT, or Russell 2000 Index options

Most traders are comfortable owning options for protection only when those options expire after the positions  being protected.  In a high IV environment, buying options with longer lifetimes is costly.  Thus, protection is expensive.

One way to handle that problem is to buy front-month options.  Those options cost significantly less than longer-term options and that allows you to buy options that are less far out of the money.  But, for most traders, it's uncomfortable to own options that don't outlast the stuff they are protecting.  I learned to get over that discomfort and am convinced that near-term options offer the best protection (Detailed discussion in The Rookie's Guide to Options.)

Most of the time your extra protection expires worthless.  Thus, your overall profit/loss depends on the cost of insurance and how well your iron condors perform.  But, these extra longs can result in a huge problem. 

Let's say expiration is approaching and you own some RUT Oct 580 puts.  If RUT declines to 590 to 600, you have good protection.  But, the time decay is large and if the market drifts lower, you will be left with long puts that expire worthless and unprotected spread positions.

How do you handle this situation? 

Possibility 1:  Trade your iron condors as you usually do.  If you decide to close the iron condor, don't allow the fact that you own insurance make you decide to keep a risky position.  If you do close, it's best to sell out your protection – unless it's still needed for insurance.

Possibility 2:  When expiration nears and you cannot tolerate the thought of your puts (now trading near $10, or higher) expiring worthless, you can sell them and buy a different put as a replacement.  You can choose the same expiration – or the next.  If you choose the next, you must move down a few strike prices unless you want to pay a large cash debit to make this switch.  It's preferable to take some cash out – when possible.  Nov 540 put (for example) does not give the same protection as Oct 580 – but it's in no danger of expiring worthless in a few days.

Possibility 3:  If you own enough extras so that your make money if RUT continues to move lower, you can sell out those extra puts one at a time in an effort to generate cash – as long as you maintain sufficient protection.

Bottom line:  If RUT plunges, you will be very happy to own those near-term puts.  But, if the timing is bad and expiration is just a few days away, you have a tough decision.  Those long puts give you plenty of positive gamma*, but time decay is vicious.  When there's enough time remaining, your foresight in buying protection can turn what would have been a risky situation into a comfortable profit.

*Gamma is the rate at which the option's delta changes; delta is the rate at which the option's value changes.

If this idea feels uncomfortable, don't try it.  It's just an idea for you to consider.  As stated above, most individual investors feel more comfortable when they don't own options that may soon expire worthless – and that always a risk when you own front-month options.

If you decide to try this idea, remember that options are relatively high priced (VIX = 45) right now and you can get some good practice in a paper trading account.


2 Responses to Buying Extra Puts as Insurance II

  1. John Heppsy 10/06/2008 at 10:36 AM #

    Good book BTW. Regarding buying protection. You hit the nail on the head with the protection being expensive with the high IV. For right now, would it be better to buy a front month spread instead of buying a front month option as insurance? The volatility is so high that buying plain options eats up all your profits from a condor. I haven’t run any numbers yet. Any thoughts?

  2. Mark 10/06/2008 at 11:29 AM #

    Better? Depends on your needs.
    Spreads are good for LIMITED protection. If you don’t have huge downside exposure, then spreads will work ok – for a couple of weeks only.
    But if you need disaster protection, you will have to buy a whole bunch of spreads or a few naked longs.
    The truth is that if I were facing this situation, I simply don’t know what I would do. Paying an IV of 56 for RVX (Russell 2000, which is what I trade) would not make me feel good.
    Just remember the first rule: Don’t go broke. If you need some puts to survive, then buy some.
    Or else take the loss on positions that are causing trouble. The high IV makes the price to cover an in the money put spread more reasonable than it would be with a lower IV. Thus, covering an opening new positions may make more sense.
    Not easy. I hope your question was rhetorical!
    Best of luck