Tag Archives | debit spreads

Limited Portfolio Protection; an Introduction

When discussing methods for protecting a portfolio from large losses, I've mentioned that I prefer a trade that allows me to own extra options – with the condition that those extra options are NOT father out of the money than my 'at risk' options.  Those extra options offer the possibility of earning a good-sized profit if and when a truly unexpected major market move occurs.

The problem with buying extras is that the cost is high.  When buying insurance, or adjusting a portfolio, one of the most difficult decisions is: How much should I pay? It's not the same situation as insuring a house against a destructive fire.  If you cannot afford to replace that house from petty cash (as most people cannot), then insurance is needed, and the cost is not the primary concern. [We all know that we pay too much for insurance, or else the insurance companies would not be profitable]

When we trade with negative gamma (credit spreads, covered calls, iron condors, etc), at some point we may be called upon to make a risk management decision, and that decision will often cost cash.  [Yes, we can always find a way to shift or roll a position for zero out of pocket cost, but that often increases risk, is not a good strategy for general use and is outside the scope of today's post].  There must be a spending limit when making a position safer to own.  At some point, the investment becomes too large, profit potential too small, and it's best to exit the trade – accepting the loss.


Spending less

Instead of buying extra options, an alternative is to buy spreads.  These are far less costly than individual options, and they offer limited protection.  I find that this is a winning trade-off under many market scenarios.  Consider this method and decide whether it has merit for your trading. 

When you buy a 10-point spread and pay $2, there is $8 worth of upside potential – if the market continues to move against your original position. That's a substantial amount of insurance at a very reasonable cost.

The problem is that these spreads are not available for $2.  By the time the market has moved far enough to convince you that risk must be reduced, these spreads may cost $5 or more.  In my opinion, paying half the maximum value of the spread is just too much to pay.

Here's an example:

You sold some call credit spreads: INDX Jan 920/930 when INDX was 840. 

  101201_ONE
figure 1

Now that INDX has moved to 890, the position is uncomfortable to hold (if it's not uncomfortable for you, at least assume it is for the basis of this discussion) and the experienced trader wants protection.

When buying debit spreads, the objective is to own spreads that are less far OTM than your current shorts because you must earn some good money from that 'protection' to partially offset the original position, which continues to lose money.  I don't know how long you would hold out before buying protection, but let's assume that no one would want to stay in this trade when the short strike (920) is breached.

Figure 2, shows an adjustment: we bought 2 INDX Jan 900/910 call spreads @ $4 each.

101201_two

figure 2

The $800 paid for the trade comes right off the bottom line, if the market reverses direction. [Of course the trader always has the choice of selling out that protection when he/she feels it is no longer needed]

The $400 debit allows a gain of $600 for each spread, so the upside disaster is reduced by $1,200.

The good and bad news about buying call debit spreads for upside protection is that the expiration profit zone is much improved (red line vs blue line).  It's good news because there is a nice area of significant profits.  The bad news is that the trader may elect to hold this trade into settlement (Market opening for each stock in the index, on the 3rd Friday of the month), and that's a very risky situation.  With the market in the best possible spot (between 910 and 920) at the close of business on Thursday, the trader is set up to take a big hit if the market opens somewhat higher on settlement Friday.  A 10-point move is not that big for an index priced above 900 (it's a 1% move).

The protection looks good, but holding to expiration provides the same high theta (good) and large negative gamma (bad) threat – as always.

 

Variations

It's less expensive to buy the call spread with the highest strikes that are not already in your position (900/910 in this example).  The advantage to that play is that you can buy more spreads for the same money as buying fewer, more costly spreads.  I vote for the 900/910. 

One variation is to buy more (or fewer) such spreads.

However, it's reasonable to buy an 890/900 or an 890/910 call spread instead. 

Another choice is to pay even less and buy the 910/920 spread.  In genral, traders shy away from this trade because it involves selling more of the option they are already short. There is no reason not to make this trade, unless it's difficult for you to examine your position and figure out exactly what you own.  I recognize that this trade adds complexity to the position for less experienced traders.  Note:  I have no objection to this adjustment, but if you find it too strange to manage, then stay away.  You can decide whether this specific adjustment type appeals to you once you gain more experience.

The last variation to consider is buying the 920/930 spread.  Because that's the position sold earlier, this 'adjustment' is merely reducing position size.  This truly is an overlooked trade.  Those who refuse to take a loss, and feel they must adjust to allow an opportunity to escape a risky trade with a profit would never consider this trade.  In my opinion, a trader should buy the call spread that seems to best serve his/her purposes.  If that happens to be the trade sold earlier, then so be it.  Don't let that stand in your way.

 

Summary

The idea of picking up some positve delta (or negative delta, when trading puts) in the form of debit spreads works as a good compromise when making adjustments for negative gamma positions.  My philosophy remains the same on one important issue:  Do not buy farther OTM options.  When short the 920 call, as in our example, the adjustment (single option or spread) should involve purchasing a call with a strike of 920 or lower.

NOTE:  A trader may choose to buy some very far OTM extras as ultimate protection.  These are NOT satisfactory to protect a position such as a troubled iron condor, credit spread, or covered call.  Recognize that this is a waste of money most of the time.  But when the payoff comes, it's a dandy.  Owning these options is not for everyone, but Nassim Taleb claims that it worked wonders for him.

849

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Adjusting iron condors: Choosing among the alternatives

Mark,

Making the "right" adjustment, at the "right" time is, by far, the most difficult part of trading iron condors, as far as I am concerned. In my real trading, the only type of adjustment I dare try is to close part of (or all) the position or roll over. All other types of adjustments seem too difficult to manage for me.

Most probably I am asking too much but , if not, and if other visitors of your blog also find it helpful, may I suggest that for a period of one or two weeks, you set up a simulation game where every day you give us a specific position (IC) and the necessary data (price of underlying, volatility, the Greeks etc) and we are asked to make a decision whether we need to adjust or not and if yes what strategy we choose, and then, the next day you give us your own proposal. I fully understand that everybody has his own comfort zone but it would be a great opportunity to see in practice how all the different adjustment strategies are used and why.

If this is not realistic, is it possible to publish in "Expiring Monthly" a new "Follow that trade" like you did last March?

Thank You

Dimitris

***

It's not realistic because of the huge amount of time required.

However, what you ask is not nearly as beneficial as you may believe it is.  Asking for the greeks?  Isn't that easy enough to do yourself?  However, that's not the point.

As a rookie, you cannot always expect to read about something and immediately put it to use.  Sure, that happens part of the time, and one example is becoming aware of the risk associated with trading too much position size.

However, not everything is so easy.   Adjusting iron condors is complex.  There is much to understand.  You cannot expect to examine a few example and then know what to do.

 

Your job

You have two main tasks: understand the adjustment method and then practice.

Understand:  Think about the reason for making an adjustment of the type under consideration.  Decide if it makes sense to you.  Try to guage the amount of risk reduction to be gained vs. the cost.  Compare with alternatives.  Decide if the whole deal fits within your comfort zone.  When you find something suitable, it's time to go to work.

Practice:  Use a paper trading account.  There's more detail on this idea below.

When

You know that I have no idea whether you should adjust when the underlying is 5% OTM, 3%, 1% or any other number.  How can I know your tolerance for risk or your investment objectives?  Or just how much you understand and how much of a beginner you are.  Each of these items, and much more must be considered when adjusting an iron condor,  Remember that there is no right answer.  There is merely something that is good for you, and hopefully you choose something very good, or even 'best' for you.

Then if you decide to adjust, I don't know if you should exit, reduce by 10 to 30%, buy a debit spread, buy a kite spread, roll, etc.  I'll go further:  If I were to tell you what to do, and not teach you how do make that decision for yourself, then I would not be fulfilling my goals. No one knows what you should do. 

I have no idea what is right for anyone but myself.  Even then I may have a difficult time making a decision.

 

My job.

I cannot show you what to do.  What I can do is offer a list of suggested strategies and try to explain why each may be a good idea, depending on conditions.  I can be certain you recognize the risk involved.  That's all I can do.

If you cannot make a good choice from the information – and I understand that as a rookie it's far from easy – then you must practice.  You suggested that I undertake a specific task.  Instead, you do it.

Each day for a week, open a new iron condor in a paper-trading account.  Each new IC should be require an immediate adjustment. Because you don't know 'when' to adjust, try this.  Open the trade based on this assumption:  It was a good, netutral trade at one time,  but now the calls (or puts) are 2% OTM. It does  not matter how much premium you collected.  It does not matter how long ago you made the trade.  Today the position is uncomfortable for you to hold.  Thus, an adjustment is in order.

Pick one adjustment method.  If you don't know which to choose, buy some credit spreads.  Guess how many.  Guess which stirkes – based on what I have previously suggested.  Try to be comfortable with the cost.

Make an adjustment.  Follow the trade.  Determine how well you like the adjustment method being tested.  They try again with another straegy.
 

Follow the trades.  Record your thoughts and collect data.  Gain experience.  That will be far more useful to you than reading my opinion on specific trades.  My objective is to teach you to think for yourself.  I know that as a beginner, you want to learn everything NOW,  That is not going to happen.  You must have some patience and learn at your own speed.  Here, practice trades offers the best learning experience.

Over several months you will collect much data and have many entries in your trade journal.  Some trades will be comfortable for you, some will not.  Be certain to record which adjustment types fall into which category. 

Among the comfortable trades, try to decide which seems to work best for you.  This is not to be determined by which makes (or save) the most money, but that is one consideration. 

Use that startegy as your primary adjustment method, but at the same time, continue the paper trading to gain more experience with other iron condor adjustment methods.  It's an ongoing proposition.

You may want to view my Oct 12, 2010 one hour webinar at TradeKing on this iron condor adjustments.

A lengthy example may be educational, but it's not a substitute for doing the work yourself.  I'm here to help or offer guidance.  But this request is more than I can handle

822

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Hedging a Portfolio of Index Iron Condors

Mark,

As a way of reducing risk from a downward move, could you recommend the
most appropriate hedge for a portfolio of index iron condors? I have
considered OTM puts, debit spreads, VIX calls & other calls on other
VIX products, even Gold & bond ETFs.

Joe

***

Joe,

I apologize for the delayed response.

There is no 'most' appropriate method or adjusting iron condors.  For some traders the primary objective is to get rid of that risk.  For them, exiting the trade is often the simplest solution.

For others, finding a good method for keeping the trade alive – and worth owning – is the objective.  To do that, trades must be made that are appropriate for the given situation.

But – here is one piece of advice: To find the best hedge for an IBM position, try to trade IBM options.  For SPX spreads, try to hedge with SPX options.

Let's take a look at your suggestions:

1) OTM options come in two categories: 

a) Those that are farther OTM than the option you are already short.  Those puts help in a black swan dive.  Not otherwise.

Why don't they help 'otherwise?'  When you own any extra OTM options and look at a risk graph, you will see that the tails of the curve point to rapidly increasing profits.

That seems to provide all the risk protection needed. The problem with that scenario is the ticking clock.  Those puts and/or calls do provide great protection.  However, you are buying these options to protect an existing position, not to deliver a huge profit on a huge market move.  Sure, that would be a nice bonus, and if you want to own black swan protection, that's okay.

But here you seek a good hedge for your iron condor portfolio.  With the iron condor, you plan to hold the trade for a while.  When you plan to hold until expiration or plan to exit sooner doesn't matter here.  The point is that as time goes by, the effectiveness of those OTM puts  that you bought or protection decreases.  They still serve as black swan protection, but do almost nothing to cut losses as your short option becomes ATM or moves ITM.

Quick example:  you are short the 900 calls.  If you buy some 920 calls, the upside looks great.  But consider that it's expiration week and the index is 895 to 905.  Your original position is causing pain (if you still own it).  And you may still own it, being mesmerized by the risk graph that shows how well you do on a move to 930.  But a move to the 910 area is a lot more likely than a  move to 930.  And time is short.  Thus, if the market trickles higher, not only does your iron condor threaten to lose the maximum, but the options you own for protection are quickly fading to zero.  The worst possible result:  Insurance is a total loss and so is the original trade.

For this reason, I do not recommend buying options that are farther OTM than your shorts – when your objective is protection. 

b) Those that are less far OTM than your current short options.  These are wonderful options to own, and afford fantastic protection.  But – they are probably more expensive than you are willing to pay.

In the example, if you owned 880 or 890
calls (bought before the market moved near 900), you would own REAL
protection.  It may be insufficient to prevent a loss, but those options
will have real value if and when the iron condor gets into trouble.

The price of these options can be reduced by applying the kite spread.  Before using kites, be absolutely positive that you understand risk as expiration nears.  Study those risk graphs.  This trade can be tricky to handle.

2) Debit spreads – which are less far OTM than your short put – help.  But they offer limited protection.  Many times the cost is too high for limited protection, but it does help.

In the example, you could buy 880/890 call spreads as partial protection.  The obvious limitation of this method is that this spread can only move to 10 points, and that may be far too little protection.  But it is one way to hedge – if it appeals to you. 

Warning:  If you pay a big price for these, then the profit potential is too small to do you any good.  If I buy these, I consider $4 for a 10-point spread to be as far as I am willing to go.

3) When looking for a debit spread to purchase, do not eliminate the spread you are currently short.  Even though that would close the trade, if that is the best spread to buy, then buy that one and lock in the loss.  Don't buy the wrong spread just to keep a poor position alive.

4) Stay away from VIX options unless you are 100% certain you know what they are and how they work.  For example, VIX is not the underlying for these options.  VIX futures are the underlying and I believe you will be best served to stay clear of VIX options.

5) VXX options may be better, but I am have not used them and do not want to offer advice that may not be accurate.  Ask Adam Warner or Bill Luby for advice.

6) Gold and bonds are out of my league.  That type of hedge does not work for me, and truthfully I know ZERO about those products. If that is your plan, you must get advice elsewhere.

784


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