Iron Condor Position, Protected by Kite Spreads

Mark,

I don't know what your positions are exactly, but let's say you
have a few kite spreads of 650/670/680 and most of your credit spreads
are at 670/680.

If RUT continues its march upwards near 670, the kite
spread hasn't reached its full potential yet (I'm not considering at
expiration – assuming there's like 30 days left). Do you plan to roll
the 670/680 position, buy back the credit spreads, or what?

In general,
what is the plan with purchasing kite spreads with strikes near
the strike you are already short?

Thanks,

Peter

***

Good question.  

In general, the kite affords protection, and I may be in (a little) less hurry to make an adjustment.  But I still adjust as I would without the insurance policy.  The kite allows flexibility, and I find that I make adjustments that were previously not a consideration.  The kite allows me to do that comfortably.

Yesterday's post explained how kiting the kite (adding a kite spread to a kite spread) represents a sound risk management technique than can provide significant profit potential when the market moves against the original iron condor position.

That post looked at the kite in isolation.  This time, let's look at it in conjunction with an existing iron condor position.

Assume:

April expiration is 42 days in the future

Short 20  RUT Apr 670/680 call spreads as part of an iron condor

Own 3 RUT Apr 650 C3 kite spreads;

+3 Apr 650 calls; and -9 Apr 670/680 call spreads

Total position:

+3 Apr 650 calls

-29 Apr 670/680 call spreads

42d

The position is short delta.  Today, the maximum loss is less than $2,500 and occurs near 690.  As time passes, the two plots merge.  The lighter blue dots represents the position with only one day remaining in the lifetime of the options.  On Apr 16, the settlement price is determined at the opening of trading.

This  position is too risky to hold that long, but it's instructive to see how the position behaves.  As time passes, the two risk graphs merge.  There is far more risk with RUT above 670 later in the game, than there is today.

Let's pause in this analysis to discuss why that is true.

If the market reverses direction, risk is reduced and previous losses are reduced or eliminated.  Thus, let's consider the position as the market rises.

The first problem is that the value of the 670/680 spread increases.  To offset that, the 3 lots of Apr 650 calls pick up value.

At the present time, with 6 weeks remaining before expiration, there is substantial time value in the 650 calls that you own.  As time passes, theta does what it does and the time premium in the option becomes less than it is today.  Thus, time is not on your side.

Of course we are also subject to the whims of a change in the implied volatility of the options, but most of the time, IV is not making big changes from week to week.  Discussing each possible scenario converts a blog post into a book, so we'll ignore IV changes.

Now, lets look at the effect of time on the 670/680 call spread.  When RUT is well below 670, the spread heads slowly towards zero.  That's good.  But that's not the area of concern.  If you own this trade when RUT is near 660 there is plenty of opportunity to exit and eliminate the ever-increasing risk.

Once again, let's only concern ourselves with the upside.  Above 680, the spread is still trading with significant time premium (today).  Thus, the value of the spread increases towards it's maximum value of $10, but it moves slowly.  And slowly is the point. 

The increase in the value of the 20 spreads is almost offset by the increase in the value of your 3-lot of long calls.  In fact, on a huge upwards move, this position earns a good profit, regardless of when it occurs.

But – there's always a 'but' – as time passes, not only does the time premium in your long call disappear, but so does the time premium in the call spread.  In other words, above 680, the spread quickly moves to $10.  Double whammy as time passes – the calls lose and the call spread loses. 

That's the reason it's so difficult to hold this position near expiration.  Risk is simply too large (for most of us).  This is clearly apparent in the light blue graph.  Late in the game, the portfolio value moves form +10k to -15k as RUT rallies from 670 to 680.

Thus, a market rise is fine now, but becomes a danger later.

Back to the question: Should you adjust now, making it safer later on – or is it okay to hold because risk is well under control for the immediate future.

As usual, I have no definitive answer.  Each of you must find his/her individual comfort zone.  But I prefer to adjust.  


to be continued… Is this position okay as is, or is an adjustment advisable?

631


"Your message of being careful, deliberate
and conservative came through loudly and clearly.  It is one of the
aspects of the book that appeals to me the most, it is not a “get rich
quick” book."  DE

TRGFCover


19 Responses to Iron Condor Position, Protected by Kite Spreads

  1. Anthony V 03/05/2010 at 5:34 AM #

    Excellent breakdown of “why”. Thanks Mark.

  2. Peter 03/05/2010 at 1:32 PM #

    Thanks Mark. As it stands right now, RUT is up more than 10 points and is very close to 670 with much time left before expiration. I’m looking forward to your next part to see what you would do.

  3. Mark Wolfinger 03/05/2010 at 2:00 PM #

    It’s not so much what I would do, it’s more a compilation of several alternative ideas. Coming 3/8/2010

  4. jp 03/06/2010 at 12:44 PM #

    Mark
    Hi, the IC hedge you call the Kite … could be more conventionally analysed into 2 components; using calls to illustrate’
    – a Skip Strike Fly | +1/0/-3/+2 or +1/0/0/-4/3 |
    – plus an extra call at the highest strike
    Looks much like one of Charles Cottles Slingshots.
    You could always rename as a Skip Strike Slingshot!
    Cheers
    James

  5. Mark Wolfinger 03/06/2010 at 1:37 PM #

    Thanks James,
    The options world lacks serious nomenclature.
    I just made up a name. I should check out those slingshots.

  6. Peter 03/07/2010 at 1:10 AM #

    Cottle started with someone wanting stock protection with puts, but didn’t want the cap of the collar, so rather than selling a call option he suggested selling 2 vertical call spreads instead to get some premium but still with unlimited upside potential. That position is equivalent to a butterfly with an extra call (1x2x2). By playing with the strike prices and changing the number of short vertical spreads, it basically looks like your kite spread – the main point being that it’s a debit spread with one free call option.

  7. Peter 03/07/2010 at 2:50 AM #

    My last post was for Mark – explaining Cottle’s slingshot and with a little history of it.
    Mark, I know it’s a comfort zone thing. My credit spreads are at 700/710, and I bought just a few (too few) kites of 660/680/690 a week ago at a good price. Since I’m an early adjuster, I have already partially rolled the 700/710. The good thing about the kite I bought was that if RUT goes to 700, the kite spread will be doing very well because the strikes I chose were quite closer to the money than the credit spreads. But I guess it’s a tradeoff – I could have bought more kites for the same price if I chose the 680/700/710 and gotten more gamma and protection if RUT goes to 700 and beyond.

  8. Mark Wolfinger 03/07/2010 at 7:24 AM #

    Yes, that definitely appears to be similar to the kite spread. The crucial portion of the trade is to own a naked long.
    I sell the vertical spreads to reduce the cost of that call (or put) option. Judging only from your explanation of his methods, Cottle sells the vertical spreads instead of selling the covered call. Makes sense.
    As I developed the idea for the kite, I began with Cottle’s idea – although I had no idea it was his because the idea came from an article by Steve Smith, writing at Minyanville.
    I maneuvered the original CC through a series of different adjustments, including that of Cottle, and ended with the kite spread.
    I prefer the kite to the verticalized covered call as explained earlier. Here’s
    Part One of a multi-part series.

  9. Mark Wolfinger 03/07/2010 at 7:33 AM #

    Yes, comfort zone.
    For me, the idea of owning protection is just that – to keep losses in line, and possibly profit by owning the extra call.
    But, it’s also ok to look at owning the insurance as a separate money-making trade, as you did.
    I would have bought the higher strike kite at lower prices – just for the protection. I may have chosen the C4 kite: Buy the 670 vs. selling FOUR 700/710s.
    Keep this in mind, and it’s one nice advantage to the kite: When making an adjustment to the 700/710 spread, you are paying a debit (probably). To compensate for that cash debit, and to allow for a profit if this market ever turns around, you should consider taking cash out of the kite.
    How? Sell the your long calls and replace them: sell the 660/670 call spread. You get some nice cash, and lose a minimum amount of upside potential. I sell such spreads when they move north of $6 – but don’t have a specific price to recommend.
    Maybe it’s time to post more about kites. There seems to be some interest.

  10. Peter 03/07/2010 at 2:27 PM #

    Mark, yes if the market turns I will most likely cash out some part of the kite especially since I’ve already rolled part of the 700/710 position.
    Cottle actually started more with a collar rather than a covered call since the protective put was always in place. He then replaces the short call with short vertical spreads. I have suggested to my friends who trade collars to look at the slingshot as a possible alternative to collars. It doesn’t get back as much premium as a short call, but it allows them to participate in a bull market.

  11. Peter 03/07/2010 at 2:46 PM #

    Back to the kite. The reason I bought a closer to the money kite (it was still quite OTM when I purchased it though) was that by the time it hit the 700/710 spread, the kite had the length to blossom with the extra long call kicking in strongly. This goes back to my original question of buying a kite so close to the credit spread, like a 680/700/710 kite. Here the kite hasn’t really kicked in much yet (compared to its potential) when RUT reaches near 700. I just felt the closer to the money kite gave more protection as the long call started working its magic going deeper in the money. But this could be just an illusion because I could get more of the 680/700/710 kites and thus own more naked long calls and more gamma protection.

  12. Mark Wolfinger 03/07/2010 at 4:13 PM #

    It’s a difficult decision. Paying a debit for the modified collar is not going to please everyone.

  13. Mark Wolfinger 03/07/2010 at 4:17 PM #

    It’s always better to have more long options.
    But there’s a practical limit on how high you can go with the strikes.
    It’s important to examine the risk profile today – and just prior to expiration. This strategy looks much worse as time passes and the underlying is trading near your vertical spread.
    There are a bunch of variables in play, so the trader must choose something that works for him/her. I agree that the CTM kite looks more attractive, especially when the market is lower.
    Thanks for the discussion

  14. Peter 03/07/2010 at 5:04 PM #

    Mark, agree with everything you say. Thanks for your time – much appreciated!

  15. james 03/08/2010 at 3:01 AM #

    Mark
    Thanks for in depth explanation and discussion.
    Can I ask what software you are using for your graphs?
    Would it be of any use to you to be able to show on one graph:
    – The Original position [Iron Condor]
    – The Adjustment [Kite]
    – The Adjusted Position [IC + Kite]
    Cheers
    James

  16. Mark Wolfinger 03/08/2010 at 7:27 AM #

    James,
    I am using the risk graphs provided by my broker, Interactive Brokers.
    I’m always interested in better software for drawing charts.

  17. tjktrader@live.com 03/09/2010 at 4:21 AM #

    Mark this is my first time here. its great to find someone with good knowledge willing to answer questions. thanks
    i have some March IC’s on the SPY in trouble. 112-116 top spread. Have adjusted by adding some March19/March31 115 calendars which gives some limited upside protection.
    Can the kite spread help protect this situation? Is it too close to expiration? I tried different strikes and months on risk graph. Can you suggest certain strikes and months?

  18. Mark Wolfinger 03/09/2010 at 8:02 AM #

    Welcome to Options for Rookies
    This question is worthy of its own blog post – coming in a few days, but you need help now. Here’s a quick reply.
    Perhaps you are trying to hard. How about simply buying a couple of extra calls and letting it go at that. Perhaps March 111 or 112. That will put a decent cushion on your potential.
    1) Calendars are of limited help and I recommend not using them. Yes, they can make a big profit, but if market heads still higher, you lose on the calendar. An adjustment must be a winner when market moves. Cannot allow yourself to lose money on a spread bought as insurance.
    2) I cannot make specific recommendations. I am not a licensed investment advisor and can suggest ideas, not specific trades.
    3) I believe you held far too long before making an effective adjustment. As I said, I don’t like calendars. They don’t provide enough help. I also recognize that intelligent people do like calendars, so that point may still be up in the air for you.
    4) Kites do poorly as expiration approaches. They are costly and lose a lot of effectiveness. Too late for a March kite.
    5) You can open an April kite. My preference is to open the spread early. For example, I would have wanted to by a March kite where the long call is less OTM than your short 112. I would have bought the 110. It’s far too late for that.
    You can buy an April, but it’s costly and you want the lowest strikes which is more costly.
    6)I don’t know what to suggest. To me you simply waited too long.
    You may want to use this morning’s decline to exit. You must know that you cannot win every time, and this appears to be one of those times.
    Of course, you can hold – that’s always a choice. But it’s risky.
    That’s more effective than rushing into a late kite.
    I rushed this reply to give you something to consider for today. More discussion coming in a few days.

  19. mswiggs 05/26/2013 at 12:14 PM #

    Great post & comments :).