Q & A. Insurance, Risk, and Uncomplicated Positions

Hello
Mark and thanks for your excellent blog! I have been considering your
thoughts on trading 2nd and 3rd month Iron Condors and did a successful
test last month, closing out the position 1 month early. I have been
trading front month RUT iron condors for an average credit of 1.00,
however I tend to leg into my trades. For example, I will first sell
the call spread as the market is rising for around 0.50 (based on some
technical analysis) and then wait for an opportunity to sell the put
spread for again around 0.50, or vice versa. On some months I do not
open up both sides of the iron condor because I don't like the risk of
one particular side and can't get enough of a credit that would give me
sufficient "breathing room" in the trade.


I had a question about your method of buying insurance. You tend to
look for higher credits in your condors and then buy extra insurance.
Would this not be similar to just opening up a wider iron condor for a
smaller credit? It would seem to make things less complicated and have
less commissions as well. I tend to think of these extra puts/call as
complicating the overall portfolio, especially in relation to your
recent posts on when you would then exit these positions (i.e. would
you exit your long puts at the same time you adjust your put spread
early?) I find the idea of opening up longer dated iron condors
intriguing but the concept of purchasing extra insurance seems to
really complicate the portfolio for me.

Tom

***

Tom,

NOTE: Overall 'risk' is a combination of how much you can lose and
the probability of losing it. Thus, 'reduced risk' can occasionally be
a confusing term. 

In today's context, I'm referring to 'dollars that can be lost' rather than the 'chances of losing those dollars.'

1) Any trading ideas I offer are meant to be something for readers
to consider. I would never tell you that you must (or even 'should')
adopt them.


What I am trying to do with this blog is to explain how options work
and how the average investor can use them. Obviously some readers are
far more experienced than others and already have ideas of their own.
That's good. If those readers think about what I have to say, they may accept
those ideas, or discard them. That's an educational process because it
gets those readers to consider alternatives and make a choice.


For the rookie, such as yourself, I'm offering ideas that you may
want to consider. But, if you are making your first few trades, we can
agree that you should take it slowly and not do anything that feels
complicated.


2) If it makes you uncomfortable, or if you don't fully understand,
please don't use such ideas. Not until you understand them well enough
to decide if they seem right for you and your trading style,
philosophy, and bankroll.


3) There is nothing wrong with legging into trades, if you believe
you have the market timing skills to do that profitably. Just
remember when you sell inexpensive spreads, it takes a decent-sized
move for the spread to widen by ten cents. That makes it tough to get
your price, even after the market moves your way.


4) Regarding selling wider spreads: NO. That INCREASES risk (larger
possible loss) with little extra to gain. That is not a good idea, and
is NOT anything similar to owning insurance. The whole idea behind any
type of insurance is to reduce the amount than may be lost.


Wider iron condors have a larger credit, not a smaller credit. Thus
I ask: Did you mean: open a wider iron condor that is FARTHER out of
the money?


If that is what you mean, that reduces 'risk' from the perspective
of: 'it reduces the probability of losing money on the trade.'


When I refer to 'reducing risk' I don't mean it that way. I use that phrase to mean: 'less money can be lost' on the trade.


5) Yes. If I am adjusting a losing put spread, I would sell out all,
or part of my extra puts. I would buy new insurance puts that are
appropriate for any new put spread that I sold.


But, if I buy in a put spread early because it became very cheap,
I'd still be tempted to hang onto my insurance. It truly depends on how
much I can get when selling those extras. If it's very few dollars, I
do not sell. Black swan events do happen. I may not want to bet on
them, but if I already own a cheap option, there is no point in giving
it away.

6) Commissions are not to be ignored.  But in today's world you can find a broker who charges less than $1.00 per option contract, with no additional 'per ticket' cost.  If you find commissions are hindering your ability to trade (and I get it, because I used to feel that way before the deep discounters arrived on the scene), you have the option to change brokers.  It's very difficult to avoid a trade just because the commissions are excessive.  If you feel that way occasionally, you must think about a new broker.  You don't have to change, but it is worth considering.


I hope this was helpful. Trading in an uncomplicated fashion is NECESSARY in order for you to remain within your comfort zone.

435



4 Responses to Q & A. Insurance, Risk, and Uncomplicated Positions

  1. Dave 09/01/2009 at 11:13 PM #

    Hi Mark, would you consider a post/ overview/ narrative on specific delta, gamma, theta and vega numbers/ thoughts you personally consider while managing your RUT portfolio?
    -REALLY enjoy your blog!

  2. Mark Wolfinger 09/02/2009 at 8:10 AM #

    Thanks Dave,
    I cannot do what you ask, because such numbers do not exist.
    Each case is a special situation because my portfolio is not just iron condors. Instead there are various amounts of protection and thus, the Greeks are insufficient to let me know when to make an adjustment.
    But here’s what I can do. The next time I face an adjustment decision, I can show my specific position (fudged to disguise the exact number of contracts I hold) and discuss my thoughts on adjustment alternatives, risk, and the Greeks. That’s the way I describe opening a position in the Rookie’s Guide to Options and there is no reason not to be able to do that as a blog discussion.
    To fulfill your request, I may consider making up a position that requires a ‘do something.’
    I cannot tell you when that will be. Right now there’s nothing close to requiring an adjustment in my portfolio.
    Good request.

  3. Tom 09/03/2009 at 10:44 AM #

    Hi Mark and thanks for the detailed response!
    In regards to using a ‘wider iron condor’, what I meant was one where the short legs are further out of the money.
    I read through your chapter on advanced risk management which described the use of pre-insurance. I was initially intrigued by your style of trading ICs that expire in 2-3 months and then buying back the spreads early. I had been trading front month ICs and had become intimately familiar with both the dangers of expiration week and settlement. I also had experienced the problems with higher gamma in these front month options in which there could be a sudden and large change in the price of the spread. One day my position would be looking good and then a day or two later if the RUT made a decent sized move, my IC position could be showing a 20-30% loss.
    I have a couple additional question about buying insurance. In a recent post on 8/25 you described selling additional front month put spreads as part of purchasing long front month puts in something like a ratio of 3:1. Is this your common practice of financing the higher costs of these closer to the money puts to use for insurance? I was assuming the purchase of these long puts would not be done in conjunction with selling additional front month spreads, although I can see how this would help finance the costs of the insurance. Is it usually too expensive to just purchase the long puts or calls as insurance without also selling additional spreads? Would this be a common way of accumulating insurance or would the simple purchase of a long put/call be more common? Also, if one is going to purchase insurance would it be recommended that they do so every month? I can foresee issues where one tries to time the purchasing of insurance and ends up without this insurance exactly during a bad month when they would have needed it.

  4. Mark Wolfinger 09/03/2009 at 12:36 PM #

    Tom,
    Another way to cut gamma trisk in fron-month iron condors is simply to exit earlier than you are exiting now.
    1) Regarding the practice of buying one put and selling farther out of the money put spreads (or similar using calls):
    As the title of that post indicates, this is just an example of an additional method for accumulating insurance. It’s neither better nor worse than other methods, It’s how it appears from your point of view that matters.
    Yes, my original writings (The Rookies Guide to Options) on this topic assumed the purchase of extra calls and/or puts would be a standalone trade – with nothing else being sold.
    But as with almost everything options related, there are always alternatives – and this newer idea is just an alternative. But more than that – it can be used as a standlone trade for times when you want to play a market bias.
    2) It’s not a question of too expensive. How much money you should invest in insurance depends on so many factors:
    If you collected large premium for your iron condors, you can afford to pay more. If the premium was small, you can afford to pay less – or perhaps not buy any insurance at all.
    If your position is near the border of your comfort zone, or if you like the idea of adjusting positions in stages, then the cost of insurance (or any adjustment) should not be your primary consideration.
    3) I don’t know which is more common. From my perspective most iron condor traders do not use insurance. They simply hold to the bitter end, or exit when too afraid. I prefer insurance.
    I don’t believe you should care which is more common. Surely one of the adjustment methods will appeal to you more than others – and it makes sense to adopt that one. But even that is too restrictive becasue different conditions will make you feel more with a different adjustment in place.
    4) Every month? It’s your comfort zone that must be satisfied. Turning a huge IC winner into a moderate winner becasue of insurance can be pshychologically and financially draining. But, I’ll take that mediocre result as a method of preventing a disaster. You must make your own decision.
    5) There are no hard and fast rules – at least that’s my opinion. Do what seems reasonable at a reasonable cost. Don’t feel you must buy insurance to protect a 5-lot iron condor for which you collected $1. But don’t ignore the risk of buying 50-lots of a $3 iron condor that is not too far OTM at the time of purchase. There are many variables and you just have to do the best you can with risk management. It’s not an exact science.
    6) Not needing it? Buying insurance comes with the hope that it’s not needed. Do you hope your home will burn this year? Do you hope to die so someone can collect on life insurance? Portfolio insurance is the same: Expensive and unnecessary most of the time. You don’t have to buy it. My ideas are meant to be considered. Then used or discarded. I’ll seldom tell you that something is necessary. If risk is managed to your satisfaction, that’s what counts. My job is to get you to think and make a good decision.
    If you try to time it, you will save money much of the time. But you must ask yourself if you can afford to be without insurance part of the time.
    Surely the answer depends on how much you have at risk and your ability to withstand that loss. If you are trading a million dollar account, you can afford to lose 50k. If you are trading a 40k account, you cannot afford to lose 50k.