I've been discussing the kite spread, suggesting that its primary function for option traders is to provide protection for an iron condor (or credit spread) position.
It's time to answer a simple question:
Why bother using a kite spread, when you can buy a call or put to protect the portfolio?
Definition of kite spread: A three-legged option position consisting of
- The string: One long call or put option
- The sail: Credit spreads
How many credit spreads are sold?
The wing option (farther OTM) is X strikes farther OTM than the string option. X = number of credit spreads.
Buy one SPX Oct 1150 call
Sell 3 SPX Oct 1200/1225 call spreads
Notice that 1225 is three 25-point strikes away from the string (1150 call), and thus, three spreads are sold)
The function of insurance is to earn a profit to offset, or partially offset, losses that result from another position. Those other positions are typically credit spreads (including iron condors).
Thus, the 'insurance position' must show a decent profit on a significant up or down move. The 'obvious' solution is to buy calls and/or puts.
But the kite is often a better choice and offers more versatility.
Let's compare the purchase of a 60-day call option with the purchase of a 60-day kite. Today, I want to make two points.
The P/L graph shows the differences.
Kite in Blue
Call in Red
Thick lines represent the position at expiration.
Thin lines represent the P/L on analysis date (in Figure one, that's 60 days prior to expiration)
Graph compares two insurance policies of approximately equal cost.
Kite: The 60-day SPX 1150 C3 kite (for nomenclature)
Call: The 60-day SPX 1200 call
Point One: On a major move, the call earns a larger profit. Specifically $2,500 more in this example. ['Kite call' is always worth $5,000 more because its strike is 50 points lower. However, after subtracting the value of the sail (3 spreads at $2,500 each), and the whole kite is worth $2,500 less than the naked long call – when underlying is above 1275 (the wing).
On a quick move higher, the call also outperforms the kite (compare thinner lines).
Point Two: The kite affords the possibility of a decent profit – and thus, provides better protection – over a wider range of SPX prices (at expiration). I don't recommend holding positions until they expire, but I know that many traders do hold that long.
How well either insurance 'policy' protects the portfolio depends on how rapidly the position being protected is losing money. That affects the strike prices chosen for your insurance position, but it does not affect which strategy works better for your individual comfort zone.
Have you reached a conclusion on kite vs. call? There's more to consider.