Tag Archives | kite spread kite spread profitability kite spread as insurance far-term vs. near term options trading iron condors

Q & A. The Kite Spread

This morning, I replied to three good questions and decided to collect them in a single post.  This is primarily intended for those of you who read Options for Rookies via RSS feed – and thus, miss many of these interesting questions and answers.


Greetings Mark:

As always thanks for the blog, books and other options education efforts. So here is a kite spread related question.

In viewing the Dan Sheridan webinars on the CBOE website I noticed that one adjustment technique he uses for (front month) iron condors and butterflies is to buy a back month option to flatten all or part of the delta of the position as the underlying moves. He uses a back month option because it has less theta than front month and because it will not melt into air as front month expiration approaches.

So, my question is how would back month long single options, when protecting/adjusting/delta hedging a front month wing spread, compare to a front month kite spread?

Happy Holidays

best,

semuren


***

HH to you as well.

1) Back month does have less theta. That's an advantage. But, it has less gamma and that's a disadvantage. In other words, sometimes the far month option works better, sometimes it's far less effective.

2) Back month options come with positive vega and that makes the level of implied volatility very significant in determining how the option you buy performs.

I perceive risk management for credit spreads to be a matter of gamma, not vega. Thus, I want high gamma options. Yes they decay faster, but they also cost far less.

If Dan is encouraging the purchase of options that are farther OTM than the options being protected,  I don't like that choice.  You cannot fight negative gamma with positive vega – especially with call options.

If he said that this is a worthwhile idea when using PUTS, I could understand. IV tends to increase when the market declines, so owning a back month put option may turn out to be a very good choice. Less gamma – not so good; more vega, good.

But I do not like this idea when protecting CALL spreads. And I don't like the idea unless current IV is low enough that buying vega feels right to you.

Please note: I don't want to seem to be wishy-washy, but I'm expressing opinion, not proven facts. I do NOT like back month options for protection. Unless IV is very low and it's downside protection that's being sought.

3) I believe you get much better protection when the options you buy as insurance are CTM (closer to the money) than the options you are short. In the kite that I recommend, we buy CTM options. I assume – due to the very high cost – that Dan is recommending options that are farther OTM (than shorts)- and that does not suit me or my comfort zone.

4) You can play with risk analysis software and make the comparison.  I don't anticipate getting to this specific problem any time soon.



Hi Mark,

What I don't understand about this strategy is this: When using it for IC's how does it consistently profit? If you do the kite on both legs, you will have two debits. It seems then that it will only profit if the underlying moves significantly, into a fairly narrow range.

If the underlying doesn't move significantly, the IC will lose.  Or am I missing something?

***


Brian,

1) The kite is intended to be used as an insurance policy to reduce the risk associated with owning iron condor positions.

2) It is not bought to 'consistently profit.'

3) No insurance policy is bought as a stand alone play to earn a profit. Yes, there are situations in which that unintended profit is earned, but that's not the purpose.

3) In the past two posts, the kite is being compared with the purchase of a strangle, and is no more costly than that strangle. If you don't like the idea of paying cash for insurance, then don't.

Insurance is what it is. It is protection and not intended to be a profit center. [ADDENDUM I want to reiterate:  it may become profitable, and it's fine to make an adjustment that can achieve that profit – but it's not the primary purpose of the adjustment]

4) The kite allows you to spend the same cash as when buying a call or put, and own (for example) the SPX 1150 call instead of the SPX 1200 call. To me that's a huge bonus.

Yes, I must still pay the cash, and that may be unsuitable for you. But in return for that cash, I get an option that expires in the same month as my iron condor.

As demonstrated in The Rookies Guide to Options, owning front-month protection is more effective than owning protection that expires at the same time as the IC. But, that is not comfortable for many traders and although more effective over the longer-term, does occasionally run into very significant problems (when insurance expires when it's CTM).

5) I don't get the last part. If the underlying does not move, the IC profits big time. It's the kite that will 'lose' – but you have an overall profit.


Hi Mark,


Thanks for the posts,they are very helpful. Just a question about when opening the Kite insurance.  If for example you open an iron condor with 60 days to go and the shorts are 70 points out of the money, after a week – 10 days RUT has moved 20/30 points towards one of your short strikes and it therefore gives very limited choices of where to open the kite spread.


My question is: is the best time to put the Kite spread on when you open the iron condor and therefore giving a wider choice or range of strikes to choose from?


Thanks


Brian


***


I've written about this previously. In fact it was in Part I of this two part post.

You are truly thinking in terms of putting the horse before the cart.  The important choice when insuring a position is WHEN to insure.  Not which method to use. 

I believe the kite has many advantages and hence the reason I'm frequently writing about it.

1) If you wait until insurance is needed (and that is a very acceptable decision), then yes , you have one (perhaps two) choices for a kite that does not overlap the original credit spread that you are protecting.

2) You do have the alternative of selling more of the spread already short, and buying the appropriate string option.

3) Yes, opening the kite early affords more choices – and I showed you the advantage of each choice: one for better profit potential (at higher cost) or one that affords good protection at a lower price. Or one in between these alternatives.

4) The decision of when to insure must NOT be based on kite alternatives. It must be based on your style. Do you want insurance now, or do you prefer to wait until a first stage adjustment is needed?

Or do you wait until the short spread is already ATM? If you do that, you will find kites to be very costly and no longer your best choice.

PLEASE UNDERSTAND: I like the kite. But I do not like it enough to tell you to go out and buy them, sacrificing your risk management plans. Adjust when YOU believe it's the right time to do so.

The kite is one alternative among many.

As an aside, I like the kite for more reasons than its ability to act as an insurance policy. But I don't want to dump all that information without a full explanation of each use for the kite. Thus, it's going to take time.

In addition, there are other topics to write about, so I may move on to something else and abandon the kite spread for a time.

However, I am working on a full-length book on the topic and will finish as quickly as I can.

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