Q & A. Buying Extra Puts as Insurance

Mark,

Great blog!  Thanks.

I lost a lot of capital last month on NDX PUT 1650/1600
spreads. I had moved them from 1750/1700 down to that level. I closed
the spread when the NDX was near the 1630 level (At that point the
theta decay would make the spread lose further as opposed to helping). 

There is something that's important to mention.  There's more than one good way to trade and manage any option position.  I'll reply according to my preferences.  That doesn't mean those should be your preferences.  I offer advice for you to consider before making your own decisions.

Trading is not for everyone.  But, I see no reason (yet) why it's not for you.  It does require that you develop good habits.

1) The theta of your longs became greater than the theta of your shorts.  That's a dangerous situation with iron condors.  It tells you that your short options are too far in the money and that your long option is close enough to being at the money that it has a higher theta than your already in-the-money short option. 

2) I'm glad to see you adjusted the position earlier.  The major factor in determining your long-term success with this strategy is your ability to manage risk.

3) You closed the position when your short calls were 30 points ITM, or after the index moved 60% of the distance between your long and short strikes.  There is no 'best' time to cover (and take your losses).  It all depends on your comfort zone and how much you are willing to risk for the potential reward.  But, I could never wait that long.

The whole idea of adjusting or closing a position is to prevent large losses.  We all hate taking losses, but you must understand that you cannot win every month when you own iron condors.  Yes, I know that if you cover at any specific point in time, the market may quickly reverse direction.  But your job, as risk manager, is to make the best decision you can make at the time the decision must be made, and then live with the results.  As risk manager you must win all arguments with your partner, the trader.  If you continue to make good decisions, you will prosper.  If you play 'woulda' 'coulda' shoulda' you will have a more difficult time.  NOTE: Good decisions are those that reduce or eliminate the danger at an appropriate time.  'Good' does not mean it turns out to be the decision that makes or saves money.

For my comfort zone, I don't like it when options move into the money and I usually give up on a trade as soon as that happens.  Holding out for 30 points is just not for me.  I am NOT saying it's wrong for you.  If you were just 'playing a directional prediction' I believe you must have a strong track record of successfully predicting direction before being willing to risk as much as you did on that idea.

4) First piece of advice I offer is this: Perhaps 50-point spreads are too wide for you – due to your slowness in closing when the short option strike was penetrated.  Consider 25-point spreads instead. There are advantages to using the wider spread, and if those are important to you, then trade where you are comfortable.

I'm looking for a clear example of how you could use cheap FOTM puts to
hedge or offset losses. I heard one person say to spend 10%-30% of the
premiums you gain from selling the spreads to buy the hedge.

How far in
advance should the hedge be purchased? Do you purchase puts that are
farther OTM than the spread you sold? Up to this point I have made ~3%
on average per month with iron condors with far out strikes. Any
insight would be greatly appreciated

I describe one method, with clear examples, for buying strangles as a hedge against iron condor positions in The Rookies Guide to Options.  If those options are too FOTM, they are unlikely to come to your rescue – especially after a little time passes. 

I think investing 30% is far too much because it severely reduces potential profits.  On occasion – such as the last week, with its multiple 4% moves – it can provide good, tradeable (sell option at a 'high' price and roll your long to a cheaper option) opportunities.  But I suggest buying extra options for protection, not for potential profit.

When to buy:  The longer you wait, the less expensive protection becomes.  But that leaves you unprotected while waiting, and I don't advise that.  My suggestion depends on which iron condors you buy.  I don't buy extras that expire later than the iron condor.  Thus, I buy same term or shorter-term.

Regarding strike price, I prefer to buy options that are nearer to the money than the options sold.  Obviously that's a costly undertaking.  I open positions with three months of lifetime, so as time passes and markets move, I am often in position to buy a few options with helpful strikes at good prices.  If you trade (as most investors do) front-month options, if you wait a couple of weeks before buying protection, it may be better to just take your profit instead of buying protection.  Thus, with front month iron condors, protection is needed shortly after buying the iron condors.

I prefer NOT to buy more of the options I already own, but that's often the most reasonable option.  If you use software to draw risk graphs (broker should supply software), allow those graphs to guide you.  You can find an acceptable risk level (but it will get worse daily).

Warning:  This protection is much less effective if too much time passes.  Owning iron condors becomes much more risky (much) as expiration nears.  That combination of factors helps me get out early.  Most traders prefer to wait for expiration to arrive, but I'm uncomfortable doing so.  It's just too risky.

One final point: Instead of spending cash on insurance, if you have the discipline to spend extra money (as needed) by acting in a timely manner to reduce risk – even when locking in losses – that may be more efficient than buying extras.

What you really need is black swan protection – and that can be had by owning a few FOTM puts and calls.

Or
maybe, what iron condor could you establish today for a 2-3% premium
earned that is properly hedged against a black swan event?

The bid/ask spreads are so wide that it is difficult to judge at what price you can open a position.  But – for my comfort zone – I would consider buying the RUT Dec 600/610; 820/830 iron condor if I could collect $3.05 or $3.10 for it.

If I bought 20 of those and collected about $6,000,I'd like to own some Oct 620 or 630 puts and 800 calls.  I don't know how many – I would create risk graph to see what it looks like with buying 3,4,5 etc  such strangles.  At about $600 apiece, you cannot afford too many.  It may suit you to buy Nov puts instead, but with implied volatility high, it's preferable to buy near-term options.

This idea of buying extra options is not for everyone.  And it is costly.  But, it gives me additional comfort zone support and that's crucial.

Use your own judgment.  If you don't like the idea of buying extra options, you may be better served by simply adjusting positions quicker than you have so far.  When buying iron condors works well, it's glorious.  But, when the markets are volatile you must expect to lose money, or at least earn less.  Protect yourself as well as you can.

Thanks,
John

Best regards,

Mark

Addendum (10/4/2008):  Discussion continued here.

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