The Trouble With Tribbles (Oops, I Mean Insurance)

I’ve proposed the purchase of insurance (Chapter 20 in The Rookie's Guide to Options, as well as on this blog) as one method for reducing risk when owning iron condor positions.  For readers who are not familiar with iron condors, these are positions that can get into trouble (lose money) when the market is volatile and makes a big enough move in either direction, but profit when markets trade in a (not too wide) range.

Martin posed a comment/question on this topic and today's post is a direct response.  It begins as follows (but please see entire comment, as Martin has much to say):

"I have to say that, after March, I'm a bit of a skeptic when it comes to condor insurance. In fact, I'd go so far as to say that it got me into trouble."


I'm very sorry to hear of your troubles, and will discuss some of the details of your situation.  And I agree with your conclusion that owning insurance does not guarantee a satisfactory result, but there are things you can do to improve the outcome.

"I thought I'd give this approach a chance. The bottom half of my March IC was originally a 360-370 put spread, with the RUT at 455. I added a March 320 put as insurance."

From my perspective, the purpose of adding March 320 puts is to own protection against extreme volatility, such as a black swan event.  There's nothing wrong with the idea of preventing losses – and even making money – if we wake up one morning to a worldwide disaster and see the market open 25 (or more)% lower.  But buying Black Swan insurance is a separate decision, and options bought for that purpose are not going to be useful when it comes to protecting against a large loss from an iron condor position.

  • Most traders hold iron condor positions until the options expire (for me and my comfort zone, that's too risky), or until expiration week.  Knowing that you plan to own the position that long screams to you that buying OTM options is not going to work, because the options are going to waste away.
  • If the options you buy for insurance increase in value due to a substantial market move, you will probably be forced to hold them for continuous protection.  The most likely result when buying OTM options is for them to expire worthless – you won't be able to risk selling them, and time will pass.
  • If they become worthless, there's still a good chance your iron condor spread can reach its maximum loss.  Now you have a double whammy.  Max loss with iron condor, coupled with a total loss on the insurance. In Martin's example, that can occur with RUT being anywhere between 320 and 360 at expiration.  That does not present a pretty picture.

When I write about buying insurance, I suggest two options.  The first is buying insurance when it's inexpensive.  And that occurs when you open your iron condor position.  That insurance appears to be costly and most traders prefer not to buy at that time.

The alternative is to buy insurance as needed.  The good news is that you buy it far less often, and that there's no need to buy both calls and puts.  The bad news is that it's expensive when bought.  Overall, buying when needed is the method with wider appeal.

Martin, you missed one key detail.  I don't suggest buying options that are further out of the money – in fact, I specifically suggest  put options with higher strike prices** [or call options with lower strike prices] than the options you sold earlier.  In your example, I'd buy buy March 380 or 390 puts.  That provides no guarantee of owning sufficient protection, but each long option would be worth 20 or 30 points if the 360/370 spread were to move completely into the money.  Not only that, but each would continue to increase in value if the index moved lower.  In other words, when insurance is needed, you have it.  Depending on how many extra puts you own, the potential loss has been reduced or eliminated.  To me, your suggestion of owning Mar 340 puts instead of 320 puts doesn't solve this problem.

Quote from 1st link in this post: "Regarding strike price, I prefer to buy options that are nearer to the money than the options sold."

I must also stress that owning insurance does not  mitigate the need to continue to monitor position risk.  Owning some Mar 380 puts still leaves you in a troublesome situation as RUT declines to 370.  Yes, your risk graph shows that if RUT drops to 300 you're in good shape, but as the decline moves from 370 to 360, the position is not going to do well.  Your must know whether it's a good idea to hold the position or close it.  If closing, at least you have some profit from the insurance to reduce the overall loss.  Or if you decide you can afford to hold – because you have insurance – you have two ways to win.  A market reversal, or another huge decline.  Most of the time closing will feel better, and insurance does provide an alternative. You must own options that will do some good, and they cannot be OTM. [Addendum: Cannot be OTM when those insurance options expire in the front-month.]

If you agree with the principle of adjusting in stages, you can buy a small amount of protection well before your short strike is breached – and then do a Stage II adjustment when the index moves closer to the strike price.  By taking this approach, you will have bought protection twice, making the situation much less risky if the strike is breached.  Obviously, if that breach never occurs, you will have done what everyone who buys insurance hopes to do – not need the insurance.

"You could
argue that I should have spent the extra money for, say, an April put
instead of March; or bought a 340 put rather than a 320"

The attractiveness of April puts is obvious when considering OTM options as insurance.  At least they will not expire worthless at the point they are needed. But I prefer owning short-term options because they are less expensive on a dollar basis and you can afford to pay for options with more useful strike prices.  In other words, I buy Mar 380 put and not Apr 350 or 360 put (in your example).  Owning near-term options when the iron condor expires in the 2nd or 3rd month is something many traders cannot bring themselves to do.  In the book, I give a detailed explanation of why I believe short term is better.  But,as with many option decisions, it's your comfort zone that must be satisfied.


For those who are not old enough to remember, 'The Trouble With Tribbles' is the title of a Star-Trek episode from 1967.



8 Responses to The Trouble With Tribbles (Oops, I Mean Insurance)

  1. rluser 04/07/2009 at 5:26 PM #

    Over the weekend I was considering possible post insurance for 1125/1150/1400/1425 Apr NDX and gave both the 1375 and 1350 calls consideration. I had considered a couple 1375 calls as the right price/performance option to salve my concerns until I carefully considered what changes in volatility would mean. At that point, for me, closing the position if it moved too far against me seemed more prudent. Reevaluation today (with more favorable insurance pricing) leads me to the same conclusion. I intend to close the position this Friday in any event.

  2. Mark Wolfinger 04/07/2009 at 6:43 PM #

    Buying calls is merely one alternative.
    Covering some, or all, of your short spreads is another alternative.
    What I like is that you did not blindly choose one. You evaluated your choices and made a decision.

  3. Martin 04/07/2009 at 7:54 PM #

    First, thanks for the long and detailed response to my comments, Mark. I wish I’d asked more questions while still in the heat of battle, rather than waiting until it was too late!
    My original rationale for choosing a near-month option as insurance, outside my short strike(*), was that I was not planning to hold the condor right to expiration, only until my profit target was reached. Its job was simply to smooth out the risk curve a bit, so that I wouldn’t have to make adjustments the moment the price started to go near my short strike.
    However, considering the outcome, I certainly see your point about this being decent insurance against “black swan” events, but not against the sort of large, steady declines we saw in early March. Your approach, adding one or two long options above the short put / below the short call(*), looks much better for that purpose.
    (*) I’m assuming that by “OTM” above, you mean “outside the short strikes”, as even your example 380 or 390 puts are still OTM in the usual sense of the term, relative to the price of the underlying.
    As for near- versus far-month insurance, I like the idea of looking for “more useful strike prices”, rather than simply reducing the time decay by going a month out. Will have to evaluate that for this month’s ICs and see how the numbers work out.
    (I suppose that, if one did buy insurance in a far month, these long contracts could be “recycled” as part of the wings of the following month’s condor, provided that the price range hasn’t shifted too much. But that’s probably just a small bonus if it happens, not something to reckon with up front.)
    Adjusting in stages also makes a lot of sense; thanks for the link to that article. I did eventually scale back my March position a bit; but by then it was already quite expensive to do so.
    Before placing my March IC initially, I spent some time looking at various strikes, quantities, etc., which might be used as insurance. What I found was that, because a high-probability condor’s reward-to-risk ratio is not that high (maybe 1:5 to 1:9), it is very easy to use up most of the initial credit on insurance, to the extent that the entire trade looks rather unattractive. At this point, one becomes tempted to sell higher (but more dangerous) deltas, so as to bring the returns up again…
    I guess we each have to find our own “sweet spot”, or comfort level, as you’re fond of pointing out.
    For this month (May expiration), keeping in mind the distinct possibility of a big pullback, my plan is to try out some of Dan Sheridan’s suggestions for trading condors in a high-volatility environment:
    – smaller numbers of condors
    – no insurance, initially
    – instead, prepare to adjust when short leg deltas hit 20-25, and/or the price of the short option approaches 1.75-2x the initial credit you received
    – adjust by taking the whole trade off, then waiting for three consecutive days without a move of 1.5 standard deviations or more before putting it back on
    Back in the saddle again!

  4. Mark Wolfinger 04/07/2009 at 8:19 PM #

    1) ” Its job was simply to smooth out the risk curve a bit, so that I wouldn’t have to make adjustments the moment the price started to go near my short strike.”
    And it does that job…but only for a short time.
    2) Yes, when buying options for protection, I want them to be ‘less OTM’ than the option you are short.
    3) And I do agree that you must evaluate your alternatives for the current position. I do not believe adjusting is something you can do by auto-pilot.
    4) If you buy ‘far term’ insurance, yes, it can be recycled.
    But it’s not theta that matters. It’s vega. If you buy 6-month puts and the market rallies, you have a big loss if IV decreases significantly. I’d rather own near-term puts and see them expire worthless, than take that vega risk.
    If IV is incredibly low and you want to own vega, that’s the time to buy other than front-month options. But the strike prices will be ‘less useful.’ It’s adopting the diagonal spread strategy with the adjustment.
    5) I like some of Dan’s methods. If you plan to adjust when delta of short option is 20ish, that’s the equivalent of adjusting in stages.
    Thanks for the discussion.

  5. Jesse L. 04/08/2009 at 7:23 PM #

    Mark, I believe that when selling covered calls, a stock will be most likely called away if the stock is above the strike price by very little (as low as $0.50). I’m a beginner in this area,but the common sense tells me that for a buyer of a covered call it would only make sense to exercise the option if the stock price is at least above the strike price plus the premium paid.
    Let’s say that I am selling XYZ April 75, and the premium paid was $1.25, so the buyer wouldn’t make any profit if the option was exercised below $76.25, and this doesn’t account for any commissions. Am I missing something here?
    Thanks, Jesse

  6. Mark Wolfinger 04/08/2009 at 11:41 PM #

    Yes, you are missing something. But don’t feel bad. Msny beginner’s don’t ‘get’ this until it’s been explained to them once.
    1) When expiration arrives, you can expect all calls that finish in the money by one penny or more to be exercised, or what you refer to as ‘called away.’
    2) Take this example. Place yourself in the position of the person who bought that Apr 75 call and paid $1.25. When expiration arrives, XYZ is $76.
    Do you understand that this option is in the money by $1.00 and has an intrinsic value of $100? I certainly hope that you see that.
    You are long that call option. You have three choices:
    a) Exercise the option, pay $75 for stock, and immediately sell stock at $76. By doing that, you get to keep that $100 of intrinsic value.
    b) Better decision is to sell the call option, collecting $100.
    c) Worst choice: Tell your broker not to exercise, allow the option to expire worthless and throw $100 into the trash.
    If you do not sell or exercise the option, you lose $125 on the trade.
    If you sell the option, you recoup $100, losing only $25.
    Do you see that there is really no choice here and that anyone who owns an option that is in the money should sell that option and collect ‘something’ rather than nothing? What difference does it make whether it’s a profit or a loss? That’s real cash that would be discarded if the option expires worthless.
    One additional point. In the way that you describe it, there is not really a ‘buyer of the covered call.’ Someone buys the call you write, but doesn’t know and doesn’t care whether the seller is covered or not. He/she buys the call for his/her own reasons. If that person still holds the call when expiration arrives, it will be exercised (or sold) if it is in the money, and not thrown away.
    Please let me now if you understand now.

  7. Blue cat 04/09/2009 at 6:35 PM #

    Hi Mark,
    With respect to insurance — or other danger mitigation strategies — what do you think of splitting a spread in two?
    Let’s assume one were short the APR RUT 470/480 call spread (sell the 470; buy the 480). After today (RUT at 468.2) one would probably be fairly uncomfortable. At current prices it would cost about 3.80 to get out of the position.
    One could pay for it by selling a 450/440 put spread for about 2.1 and a 480/490 call spread for 2.6.
    These are all mid-way prices. As calculated this would produce a credit of 0.9. But since they are mid-way prices it almost certainly wouldn’t be that large.
    After this trade, one would have at least the breathing room between 450 and 480. It’s not that much breathing room, but it’s better than being short at 470. In addition, as premium sellers time is on our side so any breathing room helps. And besides, we did take in a bit more premium.
    One might even plan to get out of either or both positions Monday if the market is fairly quite between now and then. In this case, with next week expiration week, even the few days between now and Monday should help quite a bit.
    (I did the arithmetic for all this in my head. If I made a mistake, look at the strategy rather than the numbers in this example.)