Portfolio Insurance

I've previously discussed the idea of buying extra options (calls, puts, or strangles) – not in an effort to earn a profit – but as protection for an option portfolio that loses money when the market undergoes large moves.  This is something that iron condor traders ought to consider.  NOTE:  I'm not saying everyone should buy such insurance, but every iron condor trader ought to be aware that such insurance is available.

Today I'll describe an alternative method for buying protection. This method is not 'better,' but it's less costly to make the trade.

1) Buy OTM puts.

2) Sell OTM put spreads.

3) Conditions:

    The puts you buy expire before the spreads, and have a strike price that is slightly farther out of the money. 

    Sell more spreads than you buy puts – often 5 x 2 or 3 x 1.  The lower the ratio, the better your portfolio is protected. 

    The cost of this transaction ranges from a small debit to a credit.  The idea is not to pay much cash, and if possible, collect cash. 

    Use position analysis software provided by your broker to be certain the risk profile indicates you have enough protection.  You may be forced to trade the combination at a reduced ratio to obtain sufficient protection. 

4) Risks: 

The options you buy expire first and if they become worthless (as they will most of the time), then you are short some unhedged put spreads. If far out of the money, buy them back cheaply ($0.25  or perhaps a bit more).  The cost of repurchasing these spreads is the cost of the insurance (subtract any cash you collected from the original trade).  This is pretty cheap insurance. 

    But, if the spreads are not very far OTM, then you are in a poor spot.  That's the big risk of owning this type of insurance.

  If the market has made a big move and your long options move far into the money, you should make more than enough by owning these extra puts than you lose on the put spreads.  This profit is used to offset all or part of the losses associated with your iron condor positions.

Example:  Here's one sample that I initiated two days ago:

        Bought RUT Mar 340 puts
        Sold 3x as many RUT Apr 350/360 put spreads
        Cash collected: $0.15

I don't expect to earn a profit from this spread, but if the market undergoes a rapid decline, I'll earn a profit.  If the Apr spreads are available @ $0.30 any time before Mar expiration arrives, I'll cover them.  That results in a loss, but it's very inexpensive insurance.  If necessary, I'll manage the risk when I lose the protection of the March puts.

There are different ways to play this.  Different ratio.  Strikes that are closer together.  Months further apart.  The advantage of buying nearer-term options: they cost far less (in dollars, not in IV).

Warning:  This is not a good idea as a money making trade.  It's strictly for insurance.

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4 Responses to Portfolio Insurance

  1. inkblue 02/05/2009 at 8:17 AM #

    Good advice. Do you think its necessary for retail investors to learn the math behind the option movement? I use my thinkorswim analytics, but sometimes it just isn’t accurate, so I’m wondering if it make sense to invest some time really learning the math behind options trading. At times I have no idea why I’m making or losing money in my Iron Condors. If so do you recommend any books on this topic?

  2. Mark Wolfinger 02/05/2009 at 9:01 AM #

    This is touchy. And I don’t know of any books that concentrate on this subject.
    I believe everyone should understand what they are doing when trading options (or anything else). But to me, that does NOT mean it’s necessary to learn the ‘math.’
    But, let’s not go too far. This does not mean you should ignore the ‘greeks.’ What is necessary is to understand what each greek measures (delta equals share equivalence; theta represents the daily time decay etc) and how to use them to help you manage risk. You must understand when the position is too risky for your comfort zone and pocketbook, and the greeks help you do that.
    You have no need to understand the Black-Scholes equation, other than to know which factors are used in calculating the theoretical value of an option.
    If you are mathematically inclined and have the time, then sure, it may even be fun to delve into the numbers more deeply. It may even give you a small edge. But I admit to not doing that.
    I find the following to be true: To be a successful trader (to a lesser extent this holds true for longer-term investors also) you need to master some trading skills. For example: is this options strategy appropriate for these market conditions? Example: don’t sell naked puts is a serious bear market. Recognize that choosing strategies with unlimited risk can demolish your account overnight, etc.
    More importantly, you must be disciplined and be a good risk manager. If you consistently allow losses to get large simply because you refuse to accept a loss on a given trade, that’s not the path to success.
    Of much less importance is choosing a specific strategy to trade. Yes you want to understand the strategy so you know what you are trying to accomplish (how the trade earns a profit), but the strategy is merely the tool you use to play the game. Your other skills are more important in determining your long-term success.
    To me the math is not ‘necessary. It’s not worthless and can provide insight, but it’s not necessary to make good money with options.
    As to why your iron condors lose money, the two major reasons are a) a big market move turns one of the spreads into a good-sized loser, especially whet it moves into the money. Good risk management requires not allowing that to happen; b) IC positions are short vega. that means they lose money when implied volatility (IV) increases. They make money when IV decreases. This is important: you must have an understanding of why you make/lose money. Otherwise it’s just throwing a dart and hoping for a good outcome.

  3. inkblue 02/05/2009 at 9:17 PM #

    Thanks for the quick reply. My IC was delta neutral and it didn’t make sense to me why I was losing money, but I see that Vega was increasing in value, so now that makes sense.

  4. semuren 02/06/2009 at 6:19 AM #

    Greetings Mark:
    Thanks for your blog and your dedication to teaching people about options. I bought the eponymous book, but since I had it sent to my US address and I am overseas I have not yet had a chance to take a look at it. But I will be making a trip back stateside this week so I should get a chance to look at it soon. There are a couple things I want to ask you that are related to this post. I understand if you do not want to give away all the information in the book here, though I do think that anyone who thinks your advice is of value, and who actually trades or is planning to trade options, should go a head and spend the few dollars for the book.
    Anyway, back to the questions. So could you outline the IC trade that the above insurance was used with. That way I can plug it into my software and take a look at how moving the various bits around affects the risk graph. Also, did you not buy any insurance on the call side? Also, if you have any more sort of whole model trades along these lines where you use the strangle buy, maybe you could put one of those up so that I (and others) could take a look at the risk graph. I find I need the graph and the greeks and the ability to move the parameters around to be able to get a feel for any new strategy.
    Second, Adam mentioned on his blog (Daily Options Report) that some numbers he ran showed that the optimal time to sell options (so in your terms buying an IC, among other strategies) is near the end of the prior cycle. In other words put your IC on maybe 4-6 weeks out. This is about the same timing I hear from other sources (Dan Sheridan, Think or Swim discussions, Condor Options [4-10 weeks]). I take it this has to do with the increase in rate of time decay as options near expiration (the inverse of this being the need to control gamma risk so that is why one should not just go options just before expiration). I take it from reading your blog that you trade ICs (I would sell sell but you say buy)at about 3 months from expiration. And that this cuts down on the directional risk. So, I wonder if you can compare in more detail the rational and reasons for trading back month ICs.
    Third, how do you pick the strikes for your positions? Do you use the delta of the short option? Do you look at chart support and resistance?
    Fourth, though it seems that you mostly trade RUT, I wonder if you hae a comment on why most people trade index ETF ICs (IWM, QQQQ, SPY, DIA) with two point wide spreads. I understand that one wants the hedge (the long strike) to move along with the short, and that two point is an effort to save on the commission that one would need to get the same credit for one point wide strikes, but why does everybody use two points, why not three. What I really want to know is is there a mathematical reason for this? Or is it just custom?
    Fifth, you seem to talk mostly about ICs on the blog. I have asked you about calendars before and you said that you did not trade those very much, but I think you have mentioned that you trade double diagonals. If possible could you give a bit more information on how you trade double diagonals.
    Thanks in advance and if you don’t want to give any any of all/too much of the information that is in the book here I can certainly understand.
    Best,
    Josh