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I want my investment portfolio to be insured. Which type of insurance best?

Mark,

I hope all is going well for you.

Keeping
busy; feeling good.  Thank
s.

I have been following your recent posts regarding the kite strategy. Interesting, but appears to hold
more risk than the pre-insurance model.

Just
as you choose any strike price for the option you buy – whether
it's pre insurance or purchased only when needed – you can do the same
for the kite.  Thus, you can invest fewer dollars, thereby cutting one aspect of risk.  

The
easiest method for doing that is to choose a (call) kite with higher strike
prices.  This assumes the trade will leave the original
credit spread intact.

NOTE:  There is no valid reason for leaving it intact – but it's easier for traders to manage a portfolio
when each specific trade is visible.



I also recognize that there is a price range for which the kite is less
effective.  But, I willingly trade that for gaining protection over a
more
likely price range
.  I also do not have to forfeit protection
against a black swan event.  

So when you say it holds more risk –
that depends on your point of view  You choose insurance to give protection that you want. Do not accept extra risk for protection you don't want. 
That's why the kite may not work for you.

So, I went back and reread your
chapter on how to setup the insurance. You make it clear that while an
individual trader might not fully understand how the insurance works,
it does work.


it's not that he/she wouldn't understand
so much as inexperience may make it difficult to be able to evaluate
the benefits.  After all, this is not a method I'd recommend to
everyone.  And it certainly is not for 'rookies.'  I included it for
the reasons stated:  you will not always be a rookie, and if you find
this to be a good book, it will be re-read.  More than once. At those
times, some non-rookie ideas will be far more meaningful.


 I used the model and can see that
practically
speaking, it seems to work.

Two things
are true:  Insurance may not be needed.  Insurance may be too costly.
There are benefits – and that's why we insure our homes and cars.  But
not everyone does (unless mandated by law) buy insurance.

What I would like to find out is how it
works. If you are willing to share I am very interested in the math
behind the scenes.

There's no math behind the scenes.  Using profit and loss graphs does give you a good picture of
current risk.  And if you play with (FREE VERSION) Hoadley's software, you can change the date and see what your P/L
profile looks like.  An effort, to be sure, but probably worth it for
someone who wants to better understand the choices.  I don't want you to
take my word for the benefits of insurance – because it may not be a
benefit for you.



Also, it appeared that when you presented the
pre-insurance model on the blog you used a 30-point spread between your
sold put/call and the purchased insurance put/call.

I chose a reasonable example and used it repeatedly. 


In your book it
looks like you used a 20-point spread. Is there a better option? 


I don't have a specific recommendation for how many points should separate the insurance from the spread being protected.
It depends on the price of the underlying (20 points in the $600 RUT is not the same as 20 points in the $1100 SPX).  It depends on implied volatility.  It depends on how much you want to pay for protection.

Truthfully, I make these decisions using graphs of the position.  Those provide a decent approximation of my exposure to loss.  When the risk/reward is acceptable, I know I have a position that's suitable for me.  You would probably prefer a position that differed in some aspect – perhaps subtle, perhaps significant.

Also
how do you determine the correct ratios for the insurance e.g 40
verticals to 3 protective puts? 



These are excellent questions.  With no
simple reply.


There is no 'best ratio.'  I chose my ratio based strictly on the
appearance of the P/L graph and my willingness to accept the loss
levels depicted.  This graph can be constructed to suit any needs
.


One warning: Owning far OTM options may be okay
in some scenarios, but NEVER when buying insurance.  the nature of
insurance is that you intend to hold – at least as long as you own the
position being insured.  As time passes, if your insurance options are
farther OTM than your iron condor – they will fade away and be
unhelpful.  For insurance, I strongly recommend (I'd insist, but how
can I do that when it's your money) that insurance options must be at
least ONE strike closer to the money than your short position.  And two
is better than one – if the cost is okay.  That's why I like the kite. 
It gives you better strikes at reduced cost.  And if willing to pay a
bit more, you can sell fewer spreads as part of the kite.  1 x 2 x 2 provides better portfolio protection than 1 x 3 x 3, but is more costly.


To me the 'better' option is the one with the better strike price; i.e.,
less far out of the money.  But those cost more than more distant
strikes.  It's a mental trade-off:  How much are you willing to
spend?  Think of your auto insurance.  Do you have a $250 deductible or
a $2,000 deductible?  You chose insurance based on protection wanted and
the cost of that protection.  This truly is similar.  You can get
'better' insurance but it costs more.

Also consider why you want insurance:  To prosper in a market
surprise?  To survive a market surprise?  Somewhere in-between?  Those
answers go into deciding whether to spend more dollars or fewer
dollars; whether to buy fewer close-to-the-money options, or a larger
number of cheaper options (but not too cheap).  There is no
one-size-fits all.

I'm not evading the question.  Much of this 'insurance' is art, not
science.  Part of the decision process is what 'makes you feel good and
secure.'  You know, the easiest type of insurance, and by far the least
expensive, is to own smaller positions (control position size).  That
way, even the maximum loss becomes a number with which you can live.


One reason I prefer the kite (in today's environment) is that the
markets are less volatile; the cost of owning same-month protection –
as opposed to front-month protection is much lower than it was several
months ago; and especially for rookies, it's easier to 'see what you
have' when all options expire at the same time. 

The
hidden risk is also avoided: front month options
can expire at the worst possible time: when they are not far OTM; when
they were costly options just a few days ago and are now worthless;
when the position they were protecting is too near to being ATM and the
(now) unprotected position must be adjusted or re-insured (costly),




Thank you in advance. 

BW

You are quite welcome.  Best regards.

558



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