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Iron condors: Diversification and VIX optons as hedges

Mark,

I wanted to preface my statements with saying you are providing a great site here for us traders that need a little help and (presently) at no cost to us! I just wanted to take a moment to give you some recognition for all your efforts and offer my gratitude. I try to read your blog every day during the work week. Thanks!

I wanted to get your feedback on trading ICs on multiple underlyings in an attempt to achieve diversification based upon modern portfolio theory (MPT). Do you think this just increases complexity without much benefit to the trader's portfolio?

Basically trying to construct an IC portfolio with underlyings that have no or negative correlation to one another. This has obvious benefits in theory, but I am not sure how this would perform in practice. Your thoughts and maybe a dedicated post if it gets your creative juices flowing.

Also, I was looking at attempting to hedge large moves in the underlying of my IC positions with options on the VIX, but every strategy just seems too costly to put on as a hedge. Any ideas on this?

I thought it would be a good idea since underlying price moving beyond my short strikes means the actual volatility was higher than implied and volatility should have increased. Also when volatility increases, ceteris paribus, IC value decreases. So I was researching some long delta/gamma strategies, but it seems like everything is more like a positional play on volatility and doesn't justify the cost as a hedge for my IC positions on other underlyings.

Brad

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Thanks Brad,

1) MPT is currently under attack.  Whether those attacks have merit will not be known any time soon. Once a true believer, I now have doubts as to how well MPT describes the real world.

2) Multiple underlying assets?  I believe you achieve far greater diversification by trading index options instead of individual stocks.  You also eliminate the possibility that a random bad earnings report can demolish a specific stock, but that cannot occur with a broad based index.

Small traders who find SPX, NDX and RUT to be too expensive to trade can choose the much smaller ETF options (SPY, QQQQ, IWM) instead.

3) Trading ICs in more than one index adds minor diversification, but not enough for me.  It is far easier to manage an iron condor portfolio when you have fewer, rather than more, underlyings.  I think the extra effort outweighs the benefits. 

If trouble arises, much better to be fixing one position, rather than several (simultaneously) – especially when markets are extremely volatile.

4) Bottom line: Not enough benefit and way too much complexity (for me).

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5) VIX options? NO, NO, NO.

6) Do you know that VIX options do NOT use the VIX index as the underlying?  These are options on VIX futures.  Because there are futures with different expiration dates, it is not clear which specific futures contract corresponds with which VIX option expiration. The info is available, but care must be taken.

7) VIX options are European style.  That means they cannot be exercised prior to expiration.  Thus, VIX may spike, and VIX call options may hardly move.  How is that possible?  The option is based on the futures contract, and that, in turn, trades on the estimated volatility at futures expiration.  In other words, trading these options may provide a hedge that's tiny, or it may provide an excellent hedge.  The latter occurs when the futures rallies alongside the VIX index.  That is not a common occurrence.

8) Be careful.  Huge move in underlying does NOT necessarily mean volatility was higher than expected.  Small, steady, unidirectional moves, day after day may be boringly non-volatile – but IC trader can still get hurt.  Owning VIX calls would just add to your losses.

9) The BEST hedge for an iron condor position is long gamma in the SAME underlying.  Don't try to get too fancy – especially when simple methods work very well.

Insurance is not free.  There is no getting around that.

10) When implied volatility increases, the market price of an iron condor increases

I know you get this, but because the terms 'buy' and 'sell' are often confusing when relating to iron condors, clarification is needed. When IV increases, the IC trader loses money because he/she sold the individual call and put spreads at prices lower than current prices.

529


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