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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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