I Get Stacks and Stacks of Questions. Dear Mark…

Perry-Como

Letters, we get letters, we get stacks an' stacks of letters . . .
Dear Perry . . .Would you be so kind, to fill a request, and sing the song I like best?

***

Mark

I have some questions for you on managing risk and complementing IC
positions with double diagonals. In your opinion is it smart for an IC
buyer to also trade some double diagonals to offset vega risk? I am just
getting the hang of IC trading and I don't want to over complicate
things, but I thought I would ask the question and learn more about
DD's.

Right now I am continuing with my weekly purchase of IC strategy. I
am buying 2 contracts of a RUT IC for the 3rd month (SEP right now)
roughly once a week. I choose short strikes with a delta of 10 and try
to get $1.80 per IC. Right now I have a few put spreads (6 contracts)
left from my August IC positions and have GTC orders on these offering
0.30 each. I also own 6 Sep IC's. For insurance I currently own one
July 420 Put and one July 580 call. My risk curve is fine right now but
once July expiration comes, I will lose the protection. At that point
my current plan is to buy one Aug Put and one Aug Call (I don't want to
pay for more protection right now, as the July Call and Put are still
working. Does this make sense to you?). At the same time (after July
expiration) I will switch to buying the October IC's each week, and put
in GTC orders to close my September spreads offering 0.30 each (This is
my autopilot early close plan that I really like. Of course if my short
strikes are threatened or if time left gets below 3 weeks I will
proactively close at higher prices).

What do you think about my risk management approach? Any suggestions
to improve it? Will adding a weekly DD purchase allow me to avoid
buying the call and put? I very new to trading IC's so I like the idea
of keeping it simple. But I also wonder if there is a way to get better
protection at a lower cost.

What do you think of my strategy as a whole? For getting $1.80 to
start I realize I give up a lot of this to buy back the spreads and for
protection. The math I did tells me that after paying to buy back the
spreads at 0.30, paying for insurance puts & calls and paying for
commissions I am left with a profit about $0.70 – and that is assuming
that everything goes well and I don't have to adjust.

As an aside, I was intrigued by your latest video post where you
mentioned you sold July put spreads with only two weeks left. I thought
about doing the same thing a couple of weeks ago on the call side
because my risk curve was so positive on the upside (when all my Aug
Call spreads had closed automatically for 0.30). However I decided
against it as I told myself I am still learning and didn't want the
added complications of near terms options. Right now my game plan is
"close any short spreads when there is less than 3 weeks left" (My
gut tells me that as a beginner this is prudent).

I look forward to hearing your thoughts, and suggestions. My
apologies for the long post. If you prefer that I break it up on
multiple posts I can do that.

Rgds

TR

***

Hello TR,

1) I have mentioned the advisability of combining iron condors with double diagonals to minimize vega risk.  Where have you been, oh trusted reader?

My advice is to offset all or part of the vega risk when you believe vega is reasonably priced.  Own IC  (short vega)when you believe  IV is high (and not going much higher) and own DD (long vega) when IV is low (and you suspect it's not going lower).  If you don't want to express an opinion, then it's always okay to own a combination of positions and remain near vega neutral.

2) If you get $0.90 per side for an IC, don't you find that $0.30 is too much to pay when exiting?  It's fine when two months remain before expiration, but is 30 cents comfortable for you when closing Aug spreads?  This is a question, not a criticism.   It seems to me that giving up 1/3 of the premium and buying insurance and selling low-priced spreads is a tough road to profitability.  More below.

3) Yes, your insurance program makes sense.  But you have overlooked one aspect that requires a decision on your part.  You own the July 420 put.  If the market turns south and RUT is near 440 when expiration arrives, you will own no insurance and replacing it will be costly.

Yes, it feels right to postpone buying Aug insurance options because theta will make them less costly when you buy them later.   And you already own insurance.  But, per the scenario I suggested in #3, waiting may turn out to be a costly decision.

Here's a compromise.  Consider trading 4 IC this week – collecting extra cash and use that cash to buy  a one-lot of Aug insurance.  Note the verb I used is 'consider.'  This may not feel right for you. 

4) The questions you must answer in your methodology:

a) How often will you earn that $0.70?

b) When you don't earn 70 cents, what do you anticipate your average loss will be – if you have the time to exit the trade at your convenience (i.e., not in a panic)?

c) How frequently (obviously an estimate) will you be taking that loss?

d) How much will you lose, and how often, in your worst case scenario.  Perhaps there's a gap opening or perhaps you get stubborn?

e) Combining the above calculations, how much do you expect to earn in an average year?

f) Does the reward justify the risk?

That's your bottom line.  It doesn't matter what I think of your methods.  What do you think of them?  Is 70 cents going to do it for you?  This is like any business – you must have a business plan.  Can you survive on your numbers?  If 'yes,' go for it.  If 'no' where are you going to get that extra income?

5) Do you believe that 'better protection' is available at a lower cost?  That's not generally the way insurance works.

You should want insurance that works for your positions.  The truth is I don't know what that should be.  Owning extra options is 'best' when a very large market move occurs.  But it doesn't help much if there is an IV expansion that occurs without a large move.  I may be wrong, but my belief is that you do the best you can protect yourself.  But sometimes you'll just own the wrong protection and there's nothing you can do about it.  By wrong protection I mean you lose the cost of insurance and your portfolio also loses.

6) Adding some DD positions merely provides limited insurance against an IV explosion.  If the market moves too far, these embedded calendar spreads (DD = IC + calendar) will fail to serve their purpose. [Calendar spreads lose when both options move far into the money.]

7) Regarding my sale of July (front-month) put spreads: I clearly explained that I was selling some of those ONLY because I had just bought in a much larger quantity of July spreads.  I also went out of my way to mention that I had plenty of room – riskwise – to make those sales. 

I closed the same put spread the previous day.  So for example, if I covered 10 IC and decided to sell four put spreads, I obviously can afford that risk (or otherwise I would not have been able to hold the original 10-lot).  Please don't take this the wrong way, but details matter and you should not take sentences out of context.

8) Selling near-term put spreads would not be the same for you – simply because you had not just 'made room' to trade those spreads.  Yes, prudence is intelligent at all times.

380



6 Responses to I Get Stacks and Stacks of Questions. Dear Mark…

  1. TR 07/06/2009 at 4:59 PM #

    Mark
    This was an excellent reposnse to my questions. You have given me a lot to think about. Perhaps I may be playing it “too safe” and attempting to close too early and offering too much to close. Also, I never thought about the insurance renewal scenario you described. Some real good information that you have shared with me. Thanks.
    TR

  2. TR 07/06/2009 at 5:16 PM #

    Mark
    One more comment I will make is that I am “coming over” to trading iron condors from a history of 1st) Buy and Hold Index funds and 2nd) Covered calls on those index funds/ETF’s (after reading your books). When I started covered calls writing my goal was to increase my annual returns by 1% and get 11-12% annualised (and I beleive I would have acheived that if I continued long term). I switched to IC’s mainly because IC’s fit my ambivalent view on market direction. I think with iron condors if I can get 13-14% annualised I will be more than happy.
    I love your focus on risk management and “live to trade another day” philosphy. I don’t want to be too ambitious in terms of chasing huge returns.
    Rgds
    TR

  3. Mark Wolfinger 07/06/2009 at 7:23 PM #

    TR,
    Much of what I share comes with experience. You would have figured it out soon or later. Because ‘sooner’ is better, represents a major reason for publishing this blog.
    I’m not trying to tell you that you are doing anything ‘incorrectly.’ What I’m asking you to do is consider my questions and then find appropriate answers that suit your comfort zone.
    Buying back ‘junk’ (far OTM) is a good idea. The decision is: how much to bid, and when to lower that bid.

  4. TR 07/17/2009 at 6:56 AM #

    Mark
    One more follow up question: “What is the ideal right time to buy insurance?”. I am talking about the case when you buy insurance that expires one month sooner than the IC’s (as described in the advanced risk management section of your book “The rookies guide to options”).
    I am getting into a routine of buying 3rd months IC’s and owning 2nd month puts & calls as insurance. For example right now I own a bunch on September IC’s and I own one Aug strangle as insurance. My risk curve looks great – almost flat. Next week (after July expiration) I intend to buy some October IC’s, and will keep buying Oct IC’s weekly. Would you suggest that I buy a September stangle as insurance immediately or can hold out longer as I have the protection of the Aug strangle. I have learned from your feedback (above) that waiting until the Aug expiry would be risky, but is there a “sweet spot” in terms of timing on when to buy the insurance?
    Rgds
    TR

  5. Mark Wolfinger 07/17/2009 at 8:06 AM #

    PS Please post comments on the newest relevant post. No one will see this, except for you.
    As with everything else, there is no ‘best time.’
    Note: In the book I recommend buying Aug options as insurance. Reason: Better strike prices, better gamma, less costly.
    But if you prefer to own Sep, then remember: Three choices. None is ‘best’ or ‘right’:
    a) Buy when the Aug insurance options are too far OTM to provide insurance in the real world. Yes, they are great for black swan protection, but you also want practical insurance that will help on a 10% move.
    b) It’s difficult to pay for insurance on a 2-lot. So add insurance when you ‘need’ it. That means when you have bought enough iron condors that the risk is beginning to make you uncomfortable. That may be after 2 or 3 weeks of buying Oct iron condors.
    c) Buy it when you begin. That way you will have it AT ALL TIMES.
    You ask a lot of subtle questions that do not have answers. Your comfort zone is going to have to dictate this answer.

  6. TR 07/17/2009 at 6:14 PM #

    Mark
    Thank you. I will post questions on a new post next time.
    I did have a feeling you might respond using the words “comfort zone”. Nonetheless, your advice is very good.
    One thing about my comfort zone that I discovered last week was that I was MUCH more comfortable adding to my position AFTER I had the insurance. My risk curve dictated that I could sell more IC’s with the same insurance so I did – and I ended up taking in more premium without significant additional risk (at least for today).
    Rgds
    TR