Learning to use Insurance to Protect Iron Condors

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The following (condensed version) question provides an opportunity to discuss the idea of owning extra options as insurance
against a catastrophe – when trading iron condors.


Hi Mark,

I made the following paper trade after studying Chapter 20 of your book (The Rookie's Guide to Options):

Sold 10 RUT Aug 720/730 C spreads and  BOT 1 RUT Jul 700 call as insurance.  Collected $1,391 for the spread and paid $611 for insurance;  net credit: $780.

Had I not been paper trading and able to pick up some of the bid-ask spread, I would likely have received a $1,430 credit. 

I am puzzled by the current negative theta (-2) for the position.  If RUT remains unchanged, theta would be zero on June 22 and increase to 37 by July 13, when my long call expires.

Insurance provides protection on the upside, and enables a profit on the downside, but eliminates profits from theta for 11 days.  Then theta profits are low until near the Jul expiry date. 

Is this what you would expect, or should I have increased theta on the overall transaction by selling about 13 credit spreads, rather than 10?

Do you think that this transaction represents a reasonable risk/reward if I had been able to receive that $1,430 credit? 

Norm

***

1) If
your paper trading account requires that you pay offers and sell bids,
it's not worthless, but it's pretty bad.  Ask the broker how are
you supposed to gain any useful experience trading when you cannot get
realistic prices for the trades.  I assume you enter spread orders and do not trade the options separately.

It's a good
question to ask.  If they cannot help you, find a free online site to practice.  I have no idea whether the CBOE paper trading is any good. 


2) If the Jul calls expire and if you cannot close the Aug position at favorable
prices, then you are left with a one-month iron condor and no
insurance.  Not the ideal situation.  That is the worst case scenario when using insurance.

You must decide – and yes, I know experience
makes these decisions easier – if the insurance is worth the cost.  Or
if this is the right insurance to own.  Or if this is the right iron
condor (or call spread) to own. 

Consider this scenario: It's expiration week for July and the market takes a big tumble.  Do you own enough insurance? 

Norm, insurance can be helpful.  But it is expensive and not everyone likes paying top dollar and still not being completely protected.  Remember that the least expensive insurance is to cut position size.

3) You
have two ways to make money with iron condors.  Theta.  IV decrease.  

Theta is not the end-all be-all of trading.  If theta is that important
to you, I strongly suggest you avoid buying extra
options.  There are alternatives. 

To learn to handle risk better, you want to experience a number of situations in which you incur problems.  This is my suggestion:


Follow
a bunch of trades over several months and see how they play out.  It's best if you have access to a realistic paper-trading account. 

By 'play out,' I am not suggesting that only the P/L results are important.  You want to pay attention to the positions on a daily basis. 

Decisions: Are you
comfortable with (pretend) owning these positions?  Does the long option (bought as insurance) lose time value too
quickly?  Do you feel the insurance is worth the cost? 

To do
this effectively, keep a trade diary.  Write down your thoughts every
trading day. You may like the idea of owning insurance now, but change your opinion later.  Insurance is expensive when IV is elevated.

Track positions with and without insurance.  Discover your comfort zone.  Take your time and collect useful data.

 
 

You
will have many data points and observations.  Record when insurance seems to be worthwhile due to protection.  Record when insurance feels
too costly.  Write in detail.  When you have worked through a bunch of
trades, you will have a valuable book to read.  With YOUR thoughts and
ideas that suit YOUR comfort zone. 

Manage risk – owning insurance does not suggest that you can ignore risk.  Record all thoughts
about your trades.  I can give opinions, but they will not help you in
the long run.  Develop your own.

Does this require an effort?  Yes indeed it is.  I
believe it's very worthwhile.  You gain a lot of good experience
if
you have good data and the ability to come to reasonable conclusion
about what you are seeing happen on a daily basis. Please avoid the trap of believing that winning every month means you have discovered the ideal.  When profitable, recognize if it was good fortune, or whether you did something to earn the profit.  Same with losses – truly unlucky, or did you neglect to take prudent action?


4) Iron condors have positive theta and negative gamma.  Insurance
comes with just the opposite – positive gamma and negative theta.  At
various times and RUT prices, you can expect to see theta and gamma
change.  That's because the nearer-term option are more theta and gamma
sensitive.  A change in stock price or time – affects these options more
than those in the iron condor (or half of an iron condor). Don't forget that with elevated IV, option prices are higher.  That means your naked long calls erodes much faster than it would if the premium were lower.

If owning positive theta is an essential part of
the strategy for you, then take that into consideration when choosing which option to buy as insurance. 

'Insurance' is just one idea.  Buying it when IV is
elevated, as it is now, makes that idea costly.  I don't own any
insurance at today's prices.  With high IV, I prefer to either trade
fewer iron condors, or move a bit farther OTM – reducing my need for
insurance.

5) Do I think this trade has reasonable risk/reward prospects?

This
is not the right question to ask, although I do understand why you do ask.

I don't know if you will exit
at a specific profit (or loss) level.  I don't know how aggressive you
will be when making adjustments.  I don't know how you will treat this
trade if the market moves lower. 

Thus, I  have no idea what the
risk/reward is.  The position looks reasonable.  Personally, I'd prefer
to be short (a little) more vega at these levels.  Thus,to maintain risk at a reasonable level, I'd not buy insurance and I
would trade fewer than 10 iron condors.  But that's my comfort
zone. 

To answer an earlier question: no I would not sell extra call spreads just to gain positive theta.  Theta is not a good reason to accept extra risk.

717



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19 Responses to Learning to use Insurance to Protect Iron Condors

  1. Brandy 06/15/2010 at 11:07 AM #

    In my experience, CBOE paper trading gives you two options: accept the market price for speedy order entry, or put in a limit order that doesn’t even split the bid/ask spread and wait for the execution to happen hours later if at all. I guess CBOE’s argument would be that that reflects real life trading. While surely it must not be that frustrating in every instance, it happens often enough to be a deterrent to using the site. I’d like to hear other traders’ experiences with other sites offering paper trading; maybe there’s something out there that’s more helpful.

  2. Mark Wolfinger 06/15/2010 at 11:19 AM #

    Brandy,
    Thank you.
    I now know that CBOE paper trading is unsatisfactory. Yet, there are other free accounts available.
    It doesn’t seem fair, but anyone can open, and not fund, an account at a broker and then use the account for paper trading. I hope no one has to do that.
    Readers: Suggestions for a reliable, free paper trading account?

  3. Jason 06/15/2010 at 12:07 PM #

    I bought a few Jul 35 and 43 OTM calls on BP. Nothing big, just some extra dollars to see what happens.
    Bought when stock was under $30. Closing in on $32 today but call prices are down instead of up. This is probably due to lower volatility right?

  4. Mark Wolfinger 06/15/2010 at 12:16 PM #

    Jason,
    You are correct. IV lower.
    Buying OTM calls is always a gamble.
    Buying OTM calls when IV is sky high is just foolish.
    If you get the rally, you are going to get an IV crush.
    Use an options calculator to determine the current IV. Then raise the stock price and see what the IV must be for you to earn whatever it is you are trying to earn.
    This may work out, but OTM options are almost always the wrong choice.
    Regards

  5. Steve 06/15/2010 at 1:11 PM #

    Think or Swim has a good paper trading platform. Web based or a desktop software program that is pretty decent.

  6. Mark Wolfinger 06/15/2010 at 1:14 PM #

    Thanks Steve,
    For me, it’s an ethical question:
    Is it acceptable for someone who is not going to give them any business to open a paper trading account at TOS?
    I don’t have a good answer.

  7. Jason 06/15/2010 at 2:03 PM #

    Makes sense … Im bowing out of this one early in the game. But only had to pay a few bucks to learn another lesson!
    So general rule of thumb.
    Selling makes sense when IV is high
    Buying makes sense when IV is low
    Not always of course but on the right track?

  8. GW 06/15/2010 at 2:06 PM #

    Mark – with all your experience if you only feel that less than 10K is a reasonable amount then investing in options seems to be a hobby rather than a way to create any income. Am I missing something?
    Thanks

  9. Mark Wolfinger 06/15/2010 at 2:23 PM #

    Jason,
    General rule of thumb too general.
    You wanted to wager on a RALLY. If you were bearish, then I would not disparage buying OTM PUTS.
    Although buying OTM options is a tough game, at last when you buy puts, if you are correct IV should not decline. All you fight is the clock.
    When buying OTM calls, you have to fight the clock and declining IV.
    So it’s much more involved.
    But yes, in general, buying option when IV is expected to INCREASE makes sense. Selling (not naked) options works better when IV is expected to DECREASE
    Regards

  10. Mark Wolfinger 06/15/2010 at 2:27 PM #

    Hi GW,
    If you earn $1,500 to $2,000 in one year on a $10,000 account – sure you can say it’s not a lot of money and therefore it’s just a hobby.
    But if you recognize that it is 15 to 20%, and if you also understand that you will have more money to invest later [even if only a small portion goes to options] and that compounding earnings is a mathematical miracle, then it is serious business and not a hobby. Even 10k can become a nice nest egg.
    Develop good habits when you begin trading and you will have no bad habits to break when you have more money at a later date.
    I suggest taking it seriously at all times.
    Best,

  11. Steve 06/15/2010 at 2:35 PM #

    That is a good question. I would think TOS would say that they want you to try the paper trading in hopes of liking their platform so much that you do end up giving them business. But like you, I don’t have a good answer. 🙂

  12. Mark Wolfinger 06/15/2010 at 2:45 PM #

    It is good, free advertising.
    Thus, I believe you are right. They would encourage it.

  13. Norm 06/15/2010 at 3:02 PM #

    My trading platform is IB and it limits you to to paper rading at the ask price when buying and at the bid price when selling. I use IB because of the low commissions and wanted to paper trade with IB so that I can become familiar with their risk gtraphs and what-if senerios. I estimate the real price that I would have traded at and I then keep that in mind when monitoring and analyzing the position. Norm

  14. Joe 06/15/2010 at 6:54 PM #

    Mark,
    Im reflecting on the question asked by GW and your response to it.
    If ICs are are deemed income trades then how would one generate a reasonable income on only 10 ICs a month?
    So would you say trading much larger whilst carefully managing risk with added protection unwise?

  15. Mark Wolfinger 06/15/2010 at 7:46 PM #

    Joe,
    Are you telling me that people who work for minimum wage should quit their jobs because the income is not enough?
    If all you have is $10,000 to invest, then that’s all you have. Would you suggest not bothering because it provides too little income?
    ICs are ‘deemed income trades’ because someone somewhere decided that rewards resulting from taking the risk involved with selling time premium should be called ‘income.’
    It’s not income to me. It’s earnings from an investment. If you choose to depend on those earnings to support you and your family, then indeed such earnings are income. But to most people, trading profits are intended to be saved for retirement or sending the kids to college or enjoying the luxuries. It’s supplemental income – and not the income on which they must depend.
    To generate a ‘reasonable income’ on a $10,000 account is impossible. And I trust you already knew that. You know that you cannot make 30% or 40% or whatever you call a ‘reasonable income’ on such a small investment, on a consistent basis.
    As to your final question, no, I would not call it unwise. But I don’t understand from whence that question arises. Trade ‘much larger’ when you can afford to trade much larger. Don’t wager more money on iron condors – or any other strategy – when it’s too much money for you. When you depend on your investments to provide monthly income, you are going to be trading under too much pressure and there is almost no chance you will survive.
    Place at risk (this is not the total value of your account. It is the most you can lose in a worst case scenario) money you can afford to lose and then do everything in your power to protect those funds so they are not lost. Yes, carefully manage risk. Always do that.
    Joe, to me it’s your original premise that has you perplexed – and that premise is believing that ICs are supposed to provide a living – even when there is far too little money for that to be remotely possible.
    Thanks for the opportunity to express my views on this. Do you disagree?

  16. Mark Wolfinger 06/15/2010 at 7:52 PM #

    Norm,
    Do get familiar with the risk management tools and trading platform. But do it by trading elsewhere and then monitoring the positions with IB.
    You also want to get a feel for making trades and not being forced to guess at what prices you can get filled. that’s an important part of the learning process.
    Trade enough and you will have a good idea of how much worse than the midpoints you must trade for different stocks options or different expiration months. The data is useful.
    In my opinion, the original price of the trade has absolutely nothing to do with how the trade is managed. Risk is risk and when a position is no longer good to hold – don’t hold it. It does not matter whether it’s a profit or a loss when it comes time to exit. [This is my strongly held opinion and others disagree. I don’t understand why they disagree, but they do]

  17. Joe 06/16/2010 at 12:55 AM #

    Mark,
    My question (which may have been phrased incorrectly) was pertaining to trading ICs to generate regular income on a consistent basis. I think I may have taken your response out of context as I assumed you were advocating to trade no more than 10 ICs. So to be clear I don’t disagree with your overal thoughts on ICs as income trades but would still like to know your view on trading ICs in much greater size with good risk mangement in order to generate a greater income. I ask as I have read and heard from varied sources that there are traders who do this each month and therefore would like to know if you think it’s a feasible way of trading?

  18. Mark Wolfinger 06/16/2010 at 7:26 AM #

    Joe,
    Yes, it’s feasible.
    I posted a reply, but removed it.
    I believe this deserves a separate blog post. I’ll reply tomorrow.
    Regards,
    Mark

  19. Mark Wolfinger 06/16/2010 at 7:45 AM #

    Joe’s second comment below suggests I missed something in your my reply to you:
    I do NOT feel that it’s best to trade less than 10k.
    I truly hope I never said anything like that.
    Regards