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Options Risk Management: When to Buy Insurance

Hi Mark,

Nice Post on this Kite Spread Strategy and I have one question about
these adjustments.

When to open the Insurance/Adjustment?
Which option do you prefer?

1) Buy the insurance (Call and Put) when opening the Iron Condor?
Will be cheaper, but you spend this money on every trade.

2) Buy the insurance when RUT reach a pre-determined point?

3) Buy the insurance when the overall portfolio reach X% Loss (not
realized loss), Like 15%,20%,25% of the maximum profit of the
portfolio?

4) Buy the insurance when one of the IC reach X% Loss? Will be really
hard to manage 5-10 different Iron condors in separate, right?

5) To use the pre-insurance when you open the IC with 75-90 days left you
have the risk that it will be useless if you need it only on the last
30-45 days of the IC, right?

Thank you

Fabiano

***

Hello Fabiano,

There is no 'best' time to buy insurance.  It is one of the difficult decisions made by a trader.  No one wants to spend money unnecessarily, but taking too much risk is something to avoid.

Responses correspond with your numbers:

1) I suggest pre-insurance in two scenarios: when you trade bigger size than prudence dictates – in other words, when risk is already too high at the time iron condors (or credit spreads) are opened; and when you are very conservative and preventing losses is your primary investing mantra.

2) Predetermined point(s).  I believe adjusting in stages, rather than all at once, is effective.  And yes, those adjustments can be at pre-determined points.

3) I hate the idea of X% loss.  To me that is a meaningless number.  If your portfolio reaches the point at which you are uncomfortable with current risk, that's the time to do something to reduce that risk.  And it is 100% independent of original cash collected or maximum profit potential.

I make a move when delta (or any other Greek) exceeds my comfort zone.

4) Not % loss.  Comfort zone decision.  Yes, too difficult to manage each separately.  I suggest:

a) buy an adjustment that suits the risk of your portfolio, but

b) Don't ignore individual positions when it comes time to exit.  Your overall Greeks may be fine.  Your risk/reward graph may look good.  But if one of your short credit spreads have moved into the money, there's no good reason to hold onto it.

I prefer to exit that trade – and perhaps sell out some of my insurance at the same time.  Why? Two reasons:

i) The insurance (or a portion of it) may no longer be needed because of the trade you are closing.

ii) The profit from the adjustment can be used to offset some of the pain involved when closing a trade that has not worked out well.

The key is to have a good portfolio, AFTER, the high risk trade has been closed.

5) Most of the time, you don't need all the insurance you own.  Most houses are not destroyed; most cars are not demolished etc.  There is no way to know if you will need insurance.

It's fine to refuse to pay for insurance before it's needed.  That's reasonable.  As noted, you pay more for that insurance, but many times, you save money, and not only win on the credit spread (or iron condor), but you have a double win because you pay no insurance premium.

But, then you have no black swan protection.  There is no right answer.  However, you and your risk manager personna can determine what is best for you.

The kite is far from useless as time passes.  Sure, if the market has been dull and the credit spreads are fading away quickly, then all insurance has turned out to be unnecessary.  But you could not know that in advance.

However, a late market move, even if not too large, may keep those credit spreads OTM and allow the kite to move ITM.  You could exit everything at a nice profit.

If that does not happen, then you do what people who buy insurance do:  They eat the cost of the insurance, knowing they were protected.  Insurance is not bought to collect.  It's bought to minimize/eliminate risk, and allow you to sleep at night.

***

There is an alternative not mentioned, and can be thought of as 'delayed pre-insurance':  Add to insurance at opportune times.  By that I am referring to the idea of adding a call kite when the market dips (and when call protection is not needed and is less expensive) and adding a put kite on rallies.

548

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