Options Risk Management: When to Buy Insurance

Hi Mark,

Nice Post on this Kite Spread Strategy and I have one question about
these adjustments.

When to open the Insurance/Adjustment?
Which option do you prefer?

1) Buy the insurance (Call and Put) when opening the Iron Condor?
Will be cheaper, but you spend this money on every trade.

2) Buy the insurance when RUT reach a pre-determined point?

3) Buy the insurance when the overall portfolio reach X% Loss (not
realized loss), Like 15%,20%,25% of the maximum profit of the
portfolio?

4) Buy the insurance when one of the IC reach X% Loss? Will be really
hard to manage 5-10 different Iron condors in separate, right?

5) To use the pre-insurance when you open the IC with 75-90 days left you
have the risk that it will be useless if you need it only on the last
30-45 days of the IC, right?

Thank you

Fabiano

***

Hello Fabiano,

There is no 'best' time to buy insurance.  It is one of the difficult decisions made by a trader.  No one wants to spend money unnecessarily, but taking too much risk is something to avoid.

Responses correspond with your numbers:

1) I suggest pre-insurance in two scenarios: when you trade bigger size than prudence dictates – in other words, when risk is already too high at the time iron condors (or credit spreads) are opened; and when you are very conservative and preventing losses is your primary investing mantra.

2) Predetermined point(s).  I believe adjusting in stages, rather than all at once, is effective.  And yes, those adjustments can be at pre-determined points.

3) I hate the idea of X% loss.  To me that is a meaningless number.  If your portfolio reaches the point at which you are uncomfortable with current risk, that's the time to do something to reduce that risk.  And it is 100% independent of original cash collected or maximum profit potential.

I make a move when delta (or any other Greek) exceeds my comfort zone.

4) Not % loss.  Comfort zone decision.  Yes, too difficult to manage each separately.  I suggest:

a) buy an adjustment that suits the risk of your portfolio, but

b) Don't ignore individual positions when it comes time to exit.  Your overall Greeks may be fine.  Your risk/reward graph may look good.  But if one of your short credit spreads have moved into the money, there's no good reason to hold onto it.

I prefer to exit that trade – and perhaps sell out some of my insurance at the same time.  Why? Two reasons:

i) The insurance (or a portion of it) may no longer be needed because of the trade you are closing.

ii) The profit from the adjustment can be used to offset some of the pain involved when closing a trade that has not worked out well.

The key is to have a good portfolio, AFTER, the high risk trade has been closed.

5) Most of the time, you don't need all the insurance you own.  Most houses are not destroyed; most cars are not demolished etc.  There is no way to know if you will need insurance.

It's fine to refuse to pay for insurance before it's needed.  That's reasonable.  As noted, you pay more for that insurance, but many times, you save money, and not only win on the credit spread (or iron condor), but you have a double win because you pay no insurance premium.

But, then you have no black swan protection.  There is no right answer.  However, you and your risk manager personna can determine what is best for you.

The kite is far from useless as time passes.  Sure, if the market has been dull and the credit spreads are fading away quickly, then all insurance has turned out to be unnecessary.  But you could not know that in advance.

However, a late market move, even if not too large, may keep those credit spreads OTM and allow the kite to move ITM.  You could exit everything at a nice profit.

If that does not happen, then you do what people who buy insurance do:  They eat the cost of the insurance, knowing they were protected.  Insurance is not bought to collect.  It's bought to minimize/eliminate risk, and allow you to sleep at night.

***

There is an alternative not mentioned, and can be thought of as 'delayed pre-insurance':  Add to insurance at opportune times.  By that I am referring to the idea of adding a call kite when the market dips (and when call protection is not needed and is less expensive) and adding a put kite on rallies.

548

4 Responses to Options Risk Management: When to Buy Insurance

  1. Fabiano 12/11/2009 at 5:31 AM #

    Hi Mark,
    Thanks again for a very good explanation on these possibilities of Adjustment/Insurance use.
    I agree with you on the point of manage the overall porfolio, but get out of individual positions that are damaging the portfolio like the IC leg with a short option that is ITM as you mentioned.
    From the options of adjustments I listed on the original question I really like the Predermined Point one and your stages suggestion is really good.
    I know you are very busy managing your portfolio, but if possible can you tell me your opinion about this plan for an IC portfolio with 3-5 IC’s.
    1) Find your Average Short Point for Calls and Put and Your Mid Point for the entire portfolio of IC’s
    Ex – Mid Point = 600 , Average Short Calls 680 , Average Short Puts 520
    2) Buy 10% of Max Profit in Extra Options when RUT reach 25% of Distance MidPoint to Shorts ( 620 Calls and 580 Puts)
    3) Buy Another 10% of Max Profit in Extra Options when RUT reach 50% of Distance MidPoint to Shorts (640 Calls and 540 Puts)
    4) Exit the Positions when Each one Hit the Short Side.
    Is that a Reasonable Plan?
    Not sure about use 10% on Stage 1 and 10% on Stage 2.
    Fabiano

  2. Mark Wolfinger 12/11/2009 at 8:31 AM #

    I like the predetermined point also. But do remember that by the time that underlying price (or option delta) is reached, your portfolio may look very different. When that happens, your original plan may no longer be the best choice.
    In other words, don’t blindly make the planned adjustment. Reconsider to determine if that’s is still the trade you want to make now.
    I’m busier with the blog and other projects than my trading.
    ***
    Yes your plan is reasonable, but it’s not efficient. There are other factors to consider.
    * It may be wiser to exit a near-term position rather than adjust. Thus, when you make an adjustment plays a role
    * This plan completely ignores gamma, which varies as time passes. Gamma represents the big risk
    * Obviously 25 and 50% are arbitrary numbers that varies per investor
    * Ditto for 10% of max profits
    * Also, not all positions are opened simultaneously. Thus, midpoint from where? For that midpoint to remain constant, you would be making no new trades.
    * In your example, midpoints are 640 and 560. If you exit a FOTM credit spread (for example 700/710C), your midpoints change. In fact, the midpoint is now closer to the money. Do you really want to change an adjustment point based on the fact that you closed one (not currently risky) position at a small price?
    How would you act if closing one such position suddenly altered the midpoint by enough that you would now be obligated to adjust?
    It would mean you should not have been considering that FOTM position as part of the ‘package’ that you used to calculate the midpoint.
    It means you had too much risk and should have adjusted sooner. That FOTM spread should have been removed from midpoint calculation. At what point would you do that (remove it from consideration)?
    This is very fuzzy and can get confusing. This is one reason I do not like to use rules cast in stone.
    If you want a solid rule, you must discover when to remove (and replace) a specific spread into the midpoint calculation.
    * I don’t see how this can be an effective plan. Unless to make an effort to define ‘midpoint’ so that if it is reached – it’s still a good time to make an adjustment. Remember that 10% of max profit may not be sufficient cash to do anything good for the portfolio.
    Buying options that are farther OTM than your shorts may look good on a P/L graph, but it will not work for you – most of the time.

  3. Steve Bokros 12/11/2009 at 10:57 AM #

    Mark,
    These are great articles, and I am working on my understanding of the trades/greeks. I do have one question for you. Can you tell me what your average annual return is? What is the largest drawdown in that year? How many trades (and by this I mean one trade is the original position plus adjustments)? This is to give me (and other readers) a basis for analysis of the system. Obviously, my goal is to maximize return while minimizing risk. Thanks for your information and hard work it is greatly appreciated.
    Steve

  4. Mark Wolfinger 12/11/2009 at 11:42 AM #

    Steve,
    I’m sorry, I cannot do that.
    My annual return will differ from yours simply due to the fact that risk is managed differently.
    More aggressive traders will earn (and lose) more. Very conservative trades earn or lose less.
    I can tell you that I do have losing years and that not every year is a winner.
    I will tell you that discipline and limiting risk is crucial and each of us is rewarded by, or suffers from, discipline or lack thereof.
    My results, other than as a curiosity item, do not concern you.
    Until this year, I made many trades. That’s several thousand contracts per month. I even had days with more than 2,000 contracts. No more.
    I have too much else to do – and this blog requires more time than you can imagine. I trade smaller size now, and also make fewer trades.
    I do not have a ‘system’ for you to analyze. I offer education. I alert you to various trading ideas. You then pick and choose which, if any, you want to adopt for yourself.
    Your goal is admirable. If you exercise the necessary risk management and money management, you will be well on your way to success.