Q & A. Protecting Iron Condors With Extra Strangles

Hi Mark,


It´s possible to explain in an article about how you protect your iron condors with extra calls or puts?

How do you choose the timing and the strike prices?

Thanks.

Antonio.

Hello, Antonio,Strangle

Your request is a good one and it places me in an awkward position.

I write this blog hoping to educate the average individual investor about options, and explain why options are an important investment tool. And there are millions of people who can benefit by learning to use options and option strategies to reduce the risk of investing in the stock market. 

Risk reduction is serious business, as most of today's investors have discovered.

My latest book, The Rookies Guide to Options, is a low-priced learning manual. It contains much of what I have learned over the past 33 years and is written (as is this blog) in language that makes it easy for the reader to learn. I go into much greater detail than other writers because my goal is to do more than simply teach readers how to use specific strategies. Instead, my goal is to help the reader really understand the basic properties of options and how to use them. It's a practical guide. My recommended strategies are not secret, but are commonly used.  What's different is the approach I take in explaining how to think about opening, managing, and closing positions.

If I publish the entire content of my books on the Internet, I won't be able to sell any books.  Thus, I'm hesitant to reply.

But, I'll try to answer your question.  The following goes along with my primary teaching technique: Explaining which parameters are important, telling you why each may be a good (or poor) idea for your personal investing style, and then allow you to decide for yourself whether the approach appropriate.

First:  If you trade small size – and there's nothing wrong with trading one- and two-lots, if that suits your risk profile – then there's no need to buy insurance.  Besides, it would be far too costly.

Regarding timing:  The sooner you buy protection, the sooner you are insured.  All things being equal, it's tempting to wait several days (after you open he iron condor position) to gain the benefit of time decay.  But, if something big happens and you don't have insurance, that time decay edge is going to be a costly experience.

I don't have or recommend any specific method that I use consistently.  For example, buying extra puts and calls is a very expensive proposition because we are in the midst of a very volatile market, with huge up days and huge down days. VIX is trading near it's highest level since October 1987.  To me, we are in the midst of the October 2008 massacre. 

Thus, options are very expensive right now and I don't want to recommend that anyone pay those sky-high prices to buy them.  If you adopt strategies that require insurance now, I suggest that you consider trading smaller size to reduce risk, rather than buying strangles.

But, options prices will not always be so high and if you are interested in using extra calls and puts to manage risk, here are the ideas I consider:

I decide how much cash I am willing to lose by buying insurance (I buy strangles). And make no mistake – the money spent on
insurance is lost most of the time. But that's true of all insurance policies. For me, spending 10% of the cash I collect when buying iron condors is a reasonable amount.  Greater protection costs more – which I gladly pay when I deem it necessary.

Next I must decide which puts/calls to buy. Near-term options  cost less, but they often expire before the position they are protecting.  That can be inconvenient.  Longer-term (2 or 3 months) options expire after the iron condors they are protecting, and that's a nice feature.

Near-term options have more positive gamma, and that means they gain value faster than longer term options when they 'come alive' – by that I mean when they move near, or into the money.

Near-term options have less vega. That means they are significantly less expensive (in dollar terms, even though the IV may be higher) compared with longer-term options.  When IV is high, that difference becomes even more important.  But, front-month options have more negative theta and decay more rapidly.

When buying less costly near-term options, I can afford to buy strikes that are closer to the money. And that's a major consideration. When the market moves, your insurance pays big dividends when the options move ITM. When buying longer-term options, the high premium forces me to buy strikes that are further OTM.

Then there's this HUGE risk: If you own near-term options and they expire very near the money, not only have you lost every penny paid for insurance, but your iron condor position is in jeopardy and you must now buy more insurance – and that insurance is going to be expensive because the options you want to buy are not too far OTM. This expiration of near-term protection represents a real risk because it has the potential to turn a winning trade into a loser when you lose more on the insurance than you earn from the iron condor.

In summary, there is no 'best' option to buy. There is no prescription for success.  There are so many items to consider that it's difficult to decide which options are best to own.  The cost, strike price, amount of protection you need, total number of dollars you are willing to spend, and the quantity of options you want to own – they are all part of the decision. As with most option trading decisions (at least in my opinion) so much depends on your individual comfort zone, and there is no such thing as 'one size fits all.'  In the book, I describe how and why I made my decision.

To see the effects of buying protection, you'll need software that allows you to see a risk profile of your iron condor position – with and without insurance.  Your broker should provide something you can use.

I want to add one important point:  I believe it's still a good idea to manage iron condors as stand alone spreads.  If one spread exits your comfort zone, go ahead and adjust per your usual style.  Don't allow it to maintain high risk just because you have solid protection.  Once you adjust, it's a good idea to sell out some of your insurance – or better yet, collect cash by rolling (sell current options; replace with less expensive options) to a strike price that provides suitable protection for your new iron condor.

Insurance in today’s market

If I were forced to buy protection in today's climate, I'm not sure which options I would choose. The cost of insurance is so high, I would probably opt for reducing position size and not buy strangles.  But, others may prefer to pay for insurance, regardless of cost.  That's an individual decision.

Reduced size means less potential profit, but it also reduces potential losses – and that's very important.  Not losing money should be every investors primary goal.

There is an alternative. Instead of simply buying extra strangles, you can look for different positions that have positive gamma. But remember, you do NOT want to be opening new positions with extra risk – just to get insurance. If insurance is what you need, then buy it, making a reasonable decision as to quantity and strike.

Antonio, I hope these ideas help you choose appropriate options to consider buying as insurance.  There is no single 'best' answer.

Mark

5 Responses to Q & A. Protecting Iron Condors With Extra Strangles

  1. Antonio 10/15/2008 at 6:46 AM #

    Esteemed Mark,
    I wait you have not thought on me when you put this photo, for asking things that I do not have to.
    But the truth is that your sincerity overwhelms me; Here in Spain other one had answered and why don´t you buy the book?
    I have decided that any good action must have his remuneration, and I will buy your book in gratefulness.
    I hope that your blog continues being so profitable as till now and we continue learning of a master.
    Your friend, Antonio (from Spain).

  2. Mark 10/15/2008 at 7:29 AM #

    Hello Amigo,,
    The picture is simply that of a ‘strangle.’ I hope it did not offend you.
    I appreciated receiving your question and hope the reply was useful.
    Please – buy the book ONLY if you think you can use it.
    Thanks for the kind words and I hope to be able to write this blog for years to come.
    Mark

  3. Bob 10/15/2008 at 11:06 AM #

    I recently bought your “Rookies…” book. Considering myself an experienced trader of options, I thought I’d experiment with a couple trades based on the information you provided. In late September, I took positions in November far otm RUT and NDX iron condors while also buying one October “insurance” contract one strike inside the sold puts. First time ever for buying the insurance puts. (And, based entirely on your recommendation.) Wow! Am I ever a believer now. I would have been in a deep, deep hole at this point had it not been for the insurance puts. Instead, I closed the put side of the RUT position and sold my insurance put a few days ago for a monster profit. Kudos, and much thanks.
    Here’s my question: As the Oct expiration approaches, to stay in my comfort zone, I may want to hang onto my NDX insurance put contract until the very last moment and then close it out while simultaneously closing my now extremely pricey November NDX put spread. Do I need to place an order to close my cash-settled October position or will it automatically be closed for its cash value on Friday if the market is trending down even if I don’t enter a sell order?

  4. Mark 10/15/2008 at 12:11 PM #

    Reply being written as a separate post

  5. dave 11/08/2008 at 1:08 PM #

    Mark-
    I’m buying your book based on that excellent answer! While I wait (impatiently) for it to arrive may I ask; if selling OTM covered calls and collecting dividends is my (income) strategy then would I be wise (after IV calms down a bit) to buy insurance puts w-a-y out, say a year or so? They seem relatively inexpensive and the (then fixed) cost could “amortized” over the next 12 months as I roll through various call contracts… (Commissions would be less too). Yes, I wish I’d done just that a year ago, but is this a strategy to consider going forward?
    Thanks, Dave