Covering the Cheapies

I sense complacency in this marketplace.

I know that's not saying much because implied volatility, as measured by the CBOE Volatility Index (VIX) has been creeping lower and lower – and lower VIX has been generally accepted as a sign of complacency for almost as long as the VIX has been in existence (since 1988).  When the markets are rising, investors, with short memories, lose all fear. 

When investors are not in any hurry to own options for protection, there is nothing to drive option prices higher, and as a consequence, implied volatility (and option prices) trend lower.

When markets tumble, when insurance is costly – that's when investors everywhere outbid each other to buy puts as protection for their investment portfolios – or as an outright speculation that the markets will continue lower.

What feels different this time is that I am able to close positions by  buying put spreads (these represent half of my iron condor positions) at very low prices. I admit that these far OTM spreads aren't worth all that much, but under normal conditions (whatever that means these days) no one is willing to sell cheap put spreads.  With RUT near 550, yesterday I was able to cover RUT Aug 410/420 put spreads for three and four cents. In a different account, I covered the Aug 420/430 spreads by paying five cents. I know these are far OTM, but there are still four weeks remaining before August options expire.  Any of you who have tried to buy put spreads to exit a position understand that the prices are always higher than we really want to pay to exit the trade. Not this time. That's unusual.

I'm not predicting anything, but four weeks is a long time, even if we are experiencing the summer doldrums.  I'm not staying short any spreads for a nickel.  That's prudent risk management.

Although the call portions of the iron condors haven't done as well, I own more than enough naked long call options to cover the risk.


2 Responses to Covering the Cheapies

  1. WoollyLllama 07/28/2009 at 8:28 AM #

    Why not just buy back the sold options and keep the long, albeit far OTM, put options on? Save on commissions and potential to make money to the downside if and when it goes.

  2. Mark Wolfinger 07/28/2009 at 9:17 AM #

    Hello WL,
    1) Option price is too high. Not willing to pay 25 cents for such far OTM options. I much prefer to exit my longs, collecting 20 cents for each – once I have paid that 25 cents to buy back the short. The ‘less than one penny’ commission does not affect the decision.
    If I paid 5 cents to buy, I’d be with you, and not sell my longs for 2 cents. But 20 cents is just too much (for me).
    2) When I sell a spread for $1.30 to $1.70 (for example), I must decide how much to pay to exit. In above example, an extra 20 cents represents 10+ to 15% of my total profit. That’s far too much to spend on a very long-shot speculation.
    3) I already own excellent downside protection because I own extra calls and puts. Thus, for me, a market collapse is already very profitable. Don’t need to take the against-the-odds gamble to try to earn more. If my portfolio needed the protection, I might keep the longs – or more likely spend an equal amount of cash on put options with a higher strike price.
    I know many traders keep their longs and just cover the shorts. But, I think it’s just throwing away money. If you want to own some cheap puts, surely thee are better puts to buy than Aug 420s @ 20 cents each.