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The Modified Mouse Ear Strategy. Part II

Part I

Below is the P/L graph for the 4-lot iron condor mentioned above, assuming the trade is made Dec 3, 2009, 78 days prior to February 2010 expiration.

The thick line represents P/L at February expiration and the thin line shows P/L 'today,' which may not represent the trade date.

4-lot_IC_001
 

The graphics software estimates the value of this iron condor to be $497, so let's assume you collected a premium near that price when you opened the trade. Your maximum profit (for 4 lots) is $1,988 if the options expire worthless.  If the spread reaches it's maximum value (on either end), the loss is $2,012. (Max spread value = $4,000. Subtract premium received to get max loss)

Next, let's look at the graph (with the mouse ear included), assuming RUT has moved to 625 – the price at which you suggested making the adjustment.  If that were to happen today, the value of the mouse ear is $166.  In other words, you would collect an additional $166 when making this trade:


Buy one Jan 640 C;

Sell one Feb 660 C; (this is selling an option you own)

Collect $166


The total cash in your account is now $1,988 + $166, or $2,154.

C_mouse_ear2
 

The thick blue line still represents the P/L picture at Feb expiration.

Although this graph only shows the call mouse ear, a similar picture emerges (for downside risk) when the put mouse ear is bought (small image). 

Put_mouse_ear

There is an obvious improvement is upside results when you still own this position as Jan expiration arrives.**  When RUT is >640, you have a very  nice profit range.  Between 650 and 660, much of that profit disappears as the iron condor call spread inflicts its punishment.  At maximum value for the call portion of the iron condor (RUT > 660), the original iron condor is worth $4,000, resulting in a loss of $2,012.  But, your mouse ear is worth $2,000 (you own the Jan 640 call, expiration has arrived, and it's 20 points ITM)  and you also have that $166 in cash.

**It's not so easy to sit on a position when RUT is near 640.  Your (still) valuable call option may expire worthless, handing you a nice loss (explained further below).  But if you sell it, to negate the large negative time decay, you lose the beautiful gamma that comes with this option.  The decision to hold or sell this Jan option is a high-risk/high reward play that is best avoided.  But, if you sell that Jan call, you will not be well placed (again, more below).

Thus, this trade is enough to provide outstanding protection.  Unfortunately, that protection goes away when January expiration arrives.

The graph shows the P/L through Feb expiration, which is a flat line, with a small profit, when RUT is >660.   But that graph is based on the assumption that one January call was converted into long stock after January expiration.  That's how the software is designed.  

It would be far too risky to own the equivalent of 100 shares (simply buy one Feb call and sell one Feb put, with the same strike price).  Thus, this specific graph is unreliable after Jan expiration. 

In the real world, you would be forced to make some position adjustments. Closing the spread is the simplest, but that may not appeal to you.  Next you could purchase one Feb 660 C to restore the original iron condor position, but that leaves you with an unprotected iron condor.

It seems that when this wonderful insurance expires, there are complications left behind.

If RUT < 640 at January expiration, your call is worthless and you are short one call option.  As mentioned, you can buy another Feb 660 call to complete the iron condor, or perhaps a more costly Feb 640 call to give you another mouse ear. 

Unless the index is so low that you can buy back the call portion of the iron condor at a satisfactory price, you will have to pay much more than the $166 credit you received to exchange that Feb 660 call for the, now expired, Jan 640 call.  Of course, if the index is low enough, you may be facing problems on the put side.

Summary

You may have owned good protection, but you still lose money in this situation.  The 4-lots of the iron condor would be worth approximately $2,500 (at 640 on Jan expiration day, and that price represents a loss because you collected only $1,988 +$166 for the position.  Strike one. 

The Jan 640 call would be worthless or worth little (if RUT settles* near, but higher than  640).  Strike two.  

* Settlement price is determined when the market opens on expiration Friday.  If unfamiliar with this property of European style options, I've described it previously.

And to top it off, you must pay more than $1,000 to replace the Feb 660 call.  Strike three. 

The protection is wonderful, but there is more to trading iron condors than owning protection.  You must be aware of residual risk when the insurance expires prior to the trade it's protecting.

This is not a good situation.  You have a loss, and are still short the call portion of the iron condor – with no insurance.

Bottom line:  The mouse ear afforded excellent protection, but only for a limited time.  If you are unwilling to exit the call spread, or the entire iron condor at this time (Jan expiration), you will be forced to buy more protection, seriously damaging your chances to come out a winner on this trade.

***

There are a bunch of alternative outcomes in the scenario described and I hope I was able to present this study in sufficient detail to make it understandable for every reader.  This is a complicated situation, and when planning to hold the original iron condor beyond the expiration date of the (mixed-month) mouse ear, it becomes even more complicated.

This is true for any insurance policy that expires early. This insurance is much less expensive, and often far more efficient, when it expires early, but it can leave the investor with an unhappy scenario when expiration arrives.

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