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Learning to use Insurance to Protect Iron Condors

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The following (condensed version) question provides an opportunity to discuss the idea of owning extra options as insurance
against a catastrophe – when trading iron condors.


Hi Mark,

I made the following paper trade after studying Chapter 20 of your book (The Rookie's Guide to Options):

Sold 10 RUT Aug 720/730 C spreads and  BOT 1 RUT Jul 700 call as insurance.  Collected $1,391 for the spread and paid $611 for insurance;  net credit: $780.

Had I not been paper trading and able to pick up some of the bid-ask spread, I would likely have received a $1,430 credit. 

I am puzzled by the current negative theta (-2) for the position.  If RUT remains unchanged, theta would be zero on June 22 and increase to 37 by July 13, when my long call expires.

Insurance provides protection on the upside, and enables a profit on the downside, but eliminates profits from theta for 11 days.  Then theta profits are low until near the Jul expiry date. 

Is this what you would expect, or should I have increased theta on the overall transaction by selling about 13 credit spreads, rather than 10?

Do you think that this transaction represents a reasonable risk/reward if I had been able to receive that $1,430 credit? 

Norm

***

1) If
your paper trading account requires that you pay offers and sell bids,
it's not worthless, but it's pretty bad.  Ask the broker how are
you supposed to gain any useful experience trading when you cannot get
realistic prices for the trades.  I assume you enter spread orders and do not trade the options separately.

It's a good
question to ask.  If they cannot help you, find a free online site to practice.  I have no idea whether the CBOE paper trading is any good. 


2) If the Jul calls expire and if you cannot close the Aug position at favorable
prices, then you are left with a one-month iron condor and no
insurance.  Not the ideal situation.  That is the worst case scenario when using insurance.

You must decide – and yes, I know experience
makes these decisions easier – if the insurance is worth the cost.  Or
if this is the right insurance to own.  Or if this is the right iron
condor (or call spread) to own. 

Consider this scenario: It's expiration week for July and the market takes a big tumble.  Do you own enough insurance? 

Norm, insurance can be helpful.  But it is expensive and not everyone likes paying top dollar and still not being completely protected.  Remember that the least expensive insurance is to cut position size.

3) You
have two ways to make money with iron condors.  Theta.  IV decrease.  

Theta is not the end-all be-all of trading.  If theta is that important
to you, I strongly suggest you avoid buying extra
options.  There are alternatives. 

To learn to handle risk better, you want to experience a number of situations in which you incur problems.  This is my suggestion:


Follow
a bunch of trades over several months and see how they play out.  It's best if you have access to a realistic paper-trading account. 

By 'play out,' I am not suggesting that only the P/L results are important.  You want to pay attention to the positions on a daily basis. 

Decisions: Are you
comfortable with (pretend) owning these positions?  Does the long option (bought as insurance) lose time value too
quickly?  Do you feel the insurance is worth the cost? 

To do
this effectively, keep a trade diary.  Write down your thoughts every
trading day. You may like the idea of owning insurance now, but change your opinion later.  Insurance is expensive when IV is elevated.

Track positions with and without insurance.  Discover your comfort zone.  Take your time and collect useful data.

 
 

You
will have many data points and observations.  Record when insurance seems to be worthwhile due to protection.  Record when insurance feels
too costly.  Write in detail.  When you have worked through a bunch of
trades, you will have a valuable book to read.  With YOUR thoughts and
ideas that suit YOUR comfort zone. 

Manage risk – owning insurance does not suggest that you can ignore risk.  Record all thoughts
about your trades.  I can give opinions, but they will not help you in
the long run.  Develop your own.

Does this require an effort?  Yes indeed it is.  I
believe it's very worthwhile.  You gain a lot of good experience
if
you have good data and the ability to come to reasonable conclusion
about what you are seeing happen on a daily basis. Please avoid the trap of believing that winning every month means you have discovered the ideal.  When profitable, recognize if it was good fortune, or whether you did something to earn the profit.  Same with losses – truly unlucky, or did you neglect to take prudent action?


4) Iron condors have positive theta and negative gamma.  Insurance
comes with just the opposite – positive gamma and negative theta.  At
various times and RUT prices, you can expect to see theta and gamma
change.  That's because the nearer-term option are more theta and gamma
sensitive.  A change in stock price or time – affects these options more
than those in the iron condor (or half of an iron condor). Don't forget that with elevated IV, option prices are higher.  That means your naked long calls erodes much faster than it would if the premium were lower.

If owning positive theta is an essential part of
the strategy for you, then take that into consideration when choosing which option to buy as insurance. 

'Insurance' is just one idea.  Buying it when IV is
elevated, as it is now, makes that idea costly.  I don't own any
insurance at today's prices.  With high IV, I prefer to either trade
fewer iron condors, or move a bit farther OTM – reducing my need for
insurance.

5) Do I think this trade has reasonable risk/reward prospects?

This
is not the right question to ask, although I do understand why you do ask.

I don't know if you will exit
at a specific profit (or loss) level.  I don't know how aggressive you
will be when making adjustments.  I don't know how you will treat this
trade if the market moves lower. 

Thus, I  have no idea what the
risk/reward is.  The position looks reasonable.  Personally, I'd prefer
to be short (a little) more vega at these levels.  Thus,to maintain risk at a reasonable level, I'd not buy insurance and I
would trade fewer than 10 iron condors.  But that's my comfort
zone. 

To answer an earlier question: no I would not sell extra call spreads just to gain positive theta.  Theta is not a good reason to accept extra risk.

717



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