Options for Rookies: An education resource

Thanks Mark.

I am intrigued by this idea and will explore it
further.


I found your comment about trading this for the past few months interesting.
Is this an example of why learning never stops because even a 30-odd year
veteran can still find new ideas?  [Yes]


If you were implementing this strategy [buy one call, sell ~3 call spreads]  to insure an IC, would you typically
purchase the long call/put at the start of the wing? [No]

I think I understand your use of the term bullishness as we talked about in
yesterday's blog comments. In this context, it is "fear of a bull". 

However,
more generally, one thing I don't completely grasp about these IC insurance
ideas is why is it interesting to have the possibility of big profits resulting
from a big upside market move? I know this sounds funny, but my logic is that if
one is getting into a IC because they want a non-directional play and are presumably somewhat market neutral, it would seem like this big profit on big
move idea is counter to the original idea for opening the trade.

To me, it would
seem like a more symbiotic insurance policy would be to neutralize big losses on
big move … perhaps by selling a FOTM call/put to complete the spread, which
would give better profit when things go according to the original plan.

I'm
guessing the reason to do it the way you are describing is because A.) selling the
FOTM option is probably not worth much B.) being net long on the call/put of
your insurance probably reduces your -gamma better than my proposal and that the
potential for profit on a big move is just a side-effect of -gamma reduction.
But, wanted to get your thoughts on this …

And separately, if one was wanting to put on a directional play but wanted a
profit/risk trade between a naked call and spread, is this a good candidate for
that? Or is there other strategies that would fit that bill better?

Dave

***

As markets change, the old methods don't always work as well.  No single strategy or trading style is suitable for all markets – or at least none of which I am aware. 

This trading idea is merely a continuation of my quest to find a good method of protecting iron condor positions.  And that means a method that suits my needs and fits within my comfort zone.

I share any methods that I believe would be appealing to readers.  There are many ways to hedge an iron condor or credit spread, so thinking of a new one is nothing special.

***

1) You are asking for details and I don't have them (yet).  I spend what feels to be a reasonable price for the position.  When I choose a 'better' strike price, that gives me better protection, but it costs more.  I must also choose which credit spreads, and how many, to sell.  This is a comfort zone decision, and I cannot make it for you.

2) I don't know what you mean by 'the start of the wing, but my preference is NOT to buy the strike adjacent to my short option.  It costs more, but I'd rather own an option that is 2 or 3 strikes away (out of the money by less).  There are practical reasons for this, but that discussion is beyond the scope of this lengthy post.)   This works when trading RUT, an index priced near 600; it's obviously very different when trading an individual stock.

3) I cannot speak for you, but my reason for opening the IC trade is to own a position that profits from a stable market, but which is protected against a big loss, if it a large move does occur. 

Thus, when I find myself in position to collect from a rapid surge or a black swan dive, what's wrong with that?  Do you honestly believe that your expectation of how the market will perform is worth anything?  If you believe that, just go long or short, forget hedging and collect all the money in the world.  I know my expectations don't count, and I want to own the tails of the curve.

So no, it's not at all counterproductive. 

Question for you.  If you go out for a stroll, expecting to get some exercise, do you ignore the $50 bill on the sidewalk because you had an expectation that the stroll would be money neutral?

I'm looking for reasonably priced insurance.  The fact that this one comes with an embedded lottery ticket – at no additional cost – is not a bad thing.

4) Your idea of selling FOTM spreads to 'complete' the trade does not work for me. I see the merits, and if it works for you, then please go for it.  Keep in mind the margin requirements and how much return you are trying to earn on your investment.

I cover all spreads when they get cheap enough.  I do not, nor would I recommend, that anyone sell credit spreads for a small premium.

5) The strategy described (here's the original reference), which I refer to as a 1 x 3 x 3 spread (or sometimes 1 x 4 x 4) gives me the chance to sell spreads that collect a nice premium.  That significantly reduces the cost of my long options.  And I choose strike prices that do not make current risk unacceptable.  I would not sacrifice that to sell a baby spread for pennies. Nor would I give up the tails of the curve for pennies.

Think how it would feel to find a 1,000 point gap at the opening of the market – just one time in your life – and instead of panicking with everyone else, you were locking in profits and opening new positions based on the high option prices that would result from that gap opening.

6) I have no idea whether there are spreads that 'fit the bill' better.  I'm sure there are.  But, I don't know any off the top of my head and this is not a problem I care to solve.

7) You write of gamma reduction.  At the point where the profit curve begins to accelerate towards higher profits, the position is already positive gamma – and it's accelerating.

8) Options are versatile and can be used to fit ANY scenario you contemplate.  You have the ability to use risk/reward graphs (available from your broker).  Use them.  Keep adding and subtracting options and spreads to the posiitons until you have a plot that gives you the scenario you envision.  Then decide if the cost is reasonable and whether you want to own the position.  If uncertain, use a paper trading account to take it for a test drive.

My objective in writing Options for Rookies is to provide a solid options education.  I want you to learn to think for yourself.  Please don't ask me to do your homework.  You will get much more benefit out of the exercise when you find a satisfactory solution on your own.  I hope that's  okay with you.

ADDENDUM: The 1 x 3 x 3 spread described above eventually became known at the 'kite spread.'

510


4 Responses to Options for Rookies: An education resource

  1. Dave 11/07/2009 at 1:39 PM #

    I agree with your approach in your book and on this blog.
    As for myself, I’m here to “learn to fish”, not for a few options tricks I can take and run with.
    However, I also believe that creativity is most often new synthesis of existing ideas. So, from that point of view, I’m looking for ideas that I can add to my knowledge base, which I don’t quite consider the same as asking for the answers.
    In regards to the gamma comment, I meant that when your look at an portfolio of ICs and this type of insurance protection, the insurance addition has the effect of lessennig the -gamma that exists from the ICs. However, after looking at TOS, it became obvious that my idea of selling a FOTM option to complete the spread with the naked option tends to NOT impact the -gamma of the IC. So, the only apparent trade-off to selling that FOTM option would be to “cash-in” your lottery ticket for lessening the cost of the insurance and hence better profit with the IC. For completeness, the idea I was playing around with was to buy a large spread and then sell multiple smaller spreads inside of it … for instance
    – buy 1 dec spx 1115/1145 call spread
    – sell 4 dec spx 1130/1135 call spread
    currently that FOTM 1145 call is worth around $3.50 so it would reduce your insurance price by that amount but wouldn’t give you a chance for big profit on a big move (the lottery ticket).
    I liked your analogy for a money neutral walk … I laughed.

  2. Mark Wolfinger 11/07/2009 at 3:06 PM #

    Looking for new ideas is always good I don’t know just how much experience you have with trading, but I encourage you to have a good feel for the basics before moving too far ahead.
    Dave, if you buy the 1115 call and sell four of the 1130/1135 spreads, you already own a position that can never lose money (other than the orignal debit paid to enter the trade). To see this is true:
    The worst spot for you (at expiration) is 135. The four 5-point preads become worth $2,000. The value of your long is $2,000. At higher prices, you gain 100 per point.
    Conclusion: You do not need the 1145 call. You can buy it, but you don’t need it.
    A bullish investrcan make this trade, but I would consider it only as insurance, when needed.

  3. TR 11/07/2009 at 8:07 PM #

    Hi Mark
    I have a quick question for you on something I have been thinking about…Since IV goes up on days when the market falls, do you think it is a good idea for an IC buyer to wait until a day when the market drops to initiate an IC position and thereby get a higher premium? What do you see as the downside to this approach?
    Rgds
    TR

  4. Mark Wolfinger 11/08/2009 at 10:48 AM #

    TR,
    The downside to this approach is
    a) Too much time may pass before you get a down move big enough to result in a decent-sized IV inrease
    b) The IV increase may not be sufficient to offset the time decay you failed to collect
    c) You may miss out on the very best environment for IC tradrs: a dull market