Kite vs. Call (or Put). Part II

In Part I, the discussion centered on two strategies and how they compared when used to insure the value of a portfolio against losses resulting from being short credit spreads (that includes iron condors).

The two strategies are the kite spread and the long call.

The discussion continues by examining how each of these negative theta positions holds up as time passes.

Figure 1 shows the P/L graph when the position is opened. There are 60 days remaining before expiration.

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Figure 1 (repeated for convenience)

Figure 2 shows the same position 30 days later. It may be difficult to read the numbers on the graph, but the software used to draw the plots tells me that the kite spread lost $520 over those 30 days. The call option declined in value by $708.

After 30 days, the kite has lost less value.

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Figure 2


Figure 3 illustrates the position after another 20 days have passed. Expiration arrives in 10 days. I usually recommend exiting near-term positions by this time, but it's important to follow these strategies for investors who prefer to hold positions longer (and that's most traders).

At this point in time, with SPX still trading at 1100, the kite has lost a total of $921 and the call is worth $1,031 less than our cost. The kite has lost less value, but the gap is narrowing.


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Figure 3


One of the tenets of options trading is that when you buy options, the clock is ticking and it's a good idea to sell those options quickly (after whatever it was that you hoped would happen, happened). But this time we are buying options as insurance. As long as you hold the position being insured, it's important to hold the insurance. [That insurance can be modified to lock in some cash, but that's another (long) story] That's why this time decay study is important.

This is only one example of the kite spread in action, but it seems safe to conclude that it decays more slowly than the call.

To me, the kite has an edge. It does have higher commissions, but so far, I find trade executions for the three-legged kite spread to be excellent.

If a super larger move does not occur, you are going to be better off holding the kite as an adjustment than you are when holding a call (or put or strangle).

This is just one aspect of the kite story, and I find it to be a useful strategy – and worthy of more study.  

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6 Responses to Kite vs. Call (or Put). Part II

  1. semuren 12/10/2009 at 6:25 AM #

    Greetings Mark:
    As always thanks for the blog, books and other options educations efforts. So here is a kite spread related question. In viewing the Dan Sheridan webinars on the CBOE website I have noticed that one adjustment technique he uses for (front month) iron condors and butterflies is to buy a back month option to flatten all or part of the delta of the position as the underlying moves. He uses a back month option because it has less theta than front month and because it will not melt into air as front month expiration approaches. So, my question is how would back month long single options, when protecting/adjusting/delta hedging a front month wing spread, compare to a front month kite spread?
    Happy Holidays
    best,
    semuren

  2. Brian 12/10/2009 at 7:00 AM #

    Hi Mark,
    What I don’t understand about this strategy is this: When using it for IC’s how does it consistently profit? If you do the kite on both legs, you will have two debits. It seems then that it will only profit if the underlying moves significantly, into a fairly narrow range. If the underlying doesn’t move significantly, the IC will lose. or am I missing something?

  3. Mark Wolfinger 12/10/2009 at 7:36 AM #

    HH to you as well,
    1) Back month does have less theta. That’s an advantage. But, it has less gamma and that’s a disadvantage. In other words, sometimes it works better, sometimes it’s far less effective. You can only tell after the fact, and that depends on just how far the underlying moves.
    2) Back month options come with positive vega and that makes the level of implied volatility very significant in determining how the option you buy performs.
    I perceive risk management for credit spreads to be a matter of gamma, not vega. Thus, I want high gamma options. Yes they decay faster, but they also cost far less in cash out of pocket.
    If he said that this is a worthwhile idea for using PUTS, I could undestand. IV tends to increase when the market declines, so owning a back month put option may turn out to be a very good choice. Less gamma – not so good; more vega, good.
    But I do not like this idea when protecting CALL spreads. And I don’t like the idea unless current IV is low enough that buying vega feels right to you.
    Please note: I don’t want to seem to be wishy-washy, but I’m expressing opinion, not proven facts. I do NOT like back month options for protection. Unless IV is very low and it’s downside protection being sought.
    3) I believe you get much better protection when the options you buy as insurance are CTM (closer to the money) than the options you are short. In the kite that I recommend, we buy CTM options. I assume – due to the very high cost – that Dan is recommending options that are farther OTM (than shorts)- and that does not suit me or my comfort zone.
    4) You can play with the software and make the comparison. Maybe I’ll get to it, but there is so much on my plate already that I don’t anticipate getting to this specific problem.

  4. Mark Wolfinger 12/10/2009 at 7:48 AM #

    Brian,
    1) The kite is intended to be used as an insurance policy to reduce the risk associated with owning iron condor positions.
    2) It is not bought to ‘consistently profit.’
    3) No insurance policy is bought as a stand alone play to earn a profit. Yes, there are situations in which that unintended profit is earned, but that’s not the purpose.
    3) In the past two posts, the kite is being compared with the purchase of a strangle, and is no more costly than that strangle. If you don’t like the idea of paying cash for insurance, then don’t.
    Insurance is what it is. It is protection and not a profit center.
    4) But the kite allows you to spend the same cash and own (for example) the SPX 1150 call instead of the SPX 1200 call. To me that’s a huge bonus.
    Yes, I must still pay the cash, and that may be unsuitable for you. But in return for that cash, I get an option that expires in the same month as my iron condor.
    As demonstrated in The Rookies Guide to Options, owning front-month protection is more effective than owning protection that expires at the same time as the IC. But, that is not comfortable for many traders and although more effective over the longer-term, does occasionally run into very significant problems (when insurance expires when it’s CTM).
    5) I don’t get the last part. If the underlying does not move, the IC profits big time. It’s the kite that will ‘lose’ – but you have an overall profit.

  5. semuren 12/10/2009 at 10:34 AM #

    Greetings Mark:
    Thanks for the response. I had realized that about the of back month options being less than that of front month but I had not thought about the vega being greater. That is a good point but I think it might not matter that much in this case. Before I get to the explanation for that let me clarify that the method of adjusting wingspreads by buying back month options that Dan Sheridan discusses in his CBOE videos is based on the delta of the spread and the delta of the back month option purchased. So, in theory they could be closer or farther from the money than the shorts depending on delta.
    Back to the issue of vega. The other thing that Dan Sheridan brings up in regard to this technique is to make sure the the back month option purchase does not destroy the expiration graph. He does not recommend holding to expiration, but uses the expiration graph to make sure that the adjustment makes sense. He also mentions to try not to cut the theta more than half. I think if the adjustment really changed the shape of the expiration graph and/or cut the theta too much it might mean that it is too late to use this sort of adjustment. So in terms of vega, if there is a big move the gain from the delta of the back month option should overwhelm loss from vega. If there is not a big move a drop in theta should help the overall position since as an iron condor or butterfly it should be short vega. Or at least that is my analysis. Does that seem correct to you? Again, for this sort of adjustment to work one has to do it early enough (for condors this would be well before the short strike). Also, if the market keeps trending this adjustment alone might not be enough and one might have to make other adjustments (roll) or stop out. And finally, like the kite this is insurance and so one should be happy for it to make a loss and that should mean the rest of the position is making a profit.
    One more thing, I think what Brian is trying to ask above is how would the whole position (iron condor, put kite spread and call kite spread) work. I think you gave and example of this once and I graphed it. The key seemed to be having the right proportion between number of kites and number of iron condors. Do you have a rule or guideline for this? And if you put on kites in the front month and iron condors in the back month might the whole position not start out negative theta?
    Thanks,
    semuren

  6. Mark Wolfinger 12/10/2009 at 11:19 AM #

    Wow.
    1) They will be farther OTM if based on delta. Just consider the cost, if it were CTM.
    2) When making any adjustment, you must like the position – after the adjustment is made. Thus, model the trade first. If you don’t like it, then do not make the adjustment. Find another, or exit the trade.
    NEVER own a position you do not want to own right now, at it’s current price.
    Thus,if theta is too small; if vega is too large; if risk/reward is uncomfortable, you are not required to adjust.
    Choose something appropriate for YOU.
    3) If there is a big move, the gain from delta of a back month option will not necessarily overwhelm the loss from vega.
    And don’t ignore how much the IC is losing during that ‘big move.’
    And if the move is large enuf for delta to overcome vega for far-term option, think of how much better it would have been to own a nearer-month option with much higher gamma.
    4) Yes, iron condor should be short vega. But, that is not the primary consideration when opening the trade.
    5) Owning higher gamma options makes it less likely that another adjustment will be needed. Or at least it will not be needed as quickly.
    6) Regarding Brian’s question: When adjusting, many times profit potential is significantly reduced (especially when you exit a portion of the position).
    At other times, a properly executed adjustment earns a decent profit on its own. And if that happens as the original IC fades quietly into oblivion, that’s good. The kite allows for that possibility.
    7) No guideline available. I cannot know your risk tolerance and cannot tell you how to adjust positions. Me? I trade kites one or two lots at a time, adding more, if and when needed.
    Tip: You will discover that buying vega to offset negative gamma is unworkable. I understand the temptation to do anything to avoid owning options with big neg theta.