The following is not a real position. It was chosen for illustrative purposes only. Josh requested graphs, and this is my attempt to reply.
Assume you bought 20 lots of the following iron condor: RUT Mar 390/400P; 540/550C iron condor. This is not delta neutral, but each of the short options is approximately 70 points out of the money (RUT closed yesterday @ 468.
[I cannot figure out how to post the graphs on this blog. Please click here to see these two graphs.]
The top graph represents the iron condor position and ignores the passage of time. It only shows potential risk for one point in time – today, before the market opens for trading. Although the greeks were available, I omitted them to focus on the graphs.
The lower graph is for the same position, with the addition of a 3-way spread that affords some protection against loss. Although you cannot see it now, that protection diminishes as time passes.
To get a much better feel for using risk graphs such as these, see what your broker offers in the way of risk management tools. I'm using tools supplied by Interactive Brokers.
**IMPORTANT NOTE: This method of adding insurance suits me. It is not the best, easiest, or most efficient method. The purpose of this post is to provide food for thought and with practice (paper trading) you will discover a method of buying insurance that works for you. And it's not necessary to own insurance.
1) No protection was bought for the upside. You can choose a similar spread (using calls) to protect the upside, if that appeals to you.
2) It would have been easier to buy a small quantity of naked puts (and calls). But that would have been more costly at this time.
3) Buying naked long options is a good, and less complex method for protecting one position or an entire portfolio.
4) The purpose of choosing to illustrate how this spread works is because I recently blogged about a spread of this type.
5) Please note that this insurance is less costly now, but it does have risk that is absent when you buy naked options. That risk was discussed in a previous post.
6) This 3 x 9 x 9 spread does not provide complete protection. If the market tumbles, a loss still occurs. To me, that's reasonable for an iron condor position. If that does not fit into your comfort zone, you can do this spread 4 x 9 x 9 or perhaps 4 x 12 x 12 etc. There are no hard and fast rules. The OTM April put spread is sold to offset the cost of buying naked puts as insurance.
When Mar expiration arrives, and the Mar puts expire worthless (at last that's the expectation), you must deal with the Apr spreads. I hope to be able to buy them at $0.25 cents at that time. If that happens, then the true cost of the insurance becomes $225 to repurchase 9 spreads, plus $90 paid originally. That cost does not appeal to many, but this is merely one alternative among many – when buying insurance for your portfolio.