Track That Trade Aug 18, 2011. Preparing for an adjustment

Let’s say we are leery of opening new iron condor positions in this volatile market.

True, we can collect a higher premium for our initial trade. Yes, we can elect to collect the same premium as we usually do – and choose options that are farther out of the money.

Sometimes those benefits are not good enough, especially when we see our underlying asset undergo a three to six percent change in a single trading day. When that happens the options we sold may have moved too near to being at the money. Or the delta of our short options is now much higher (due to a big increase in implied volatility) than we expected it to be after a move of this size. Either of these situations could upset our trade plan and require us to exit, or otherwise adjust the trade.

The question becomes: Can we do something for an iron condor trade – at the time we enter the trade – that makes it easier to deal with the situation described above? And if there is such a trade, can it made at a reasonable cost?

The general idea

This discussion continues along the lines originated earlier, in its own blog post. The only point from that discussion that I’ll continue here is the method of adjustment.

Assumptions

Important: These are the assumptions that I chose for the purposes of this post. I hope it’s obvious that you may make other choices, to suit your individual comfort zone.

  • Adjust when the short option is 10 points OTM
  • To adjust, buy back the threatened call or put spread
  • Sell new spread. Short option is 15 delta. Expiration date is the same
  • Trade Plan: Adjust if RUT moves to 540, or within 10 points of the strike of our short option.
  • Trade plan: We should know in advance (but may change our minds) if we plan to adjust a 2nd time, or exit. However, that point is not relevant for this discussion

The new idea

When opening the iron condor, we are going to buy protection. I’ve blogged about insuring iron condor trades, but this is different.

Insurance is concerned with protecting the original investment and paying an extra premium to limit losses beyond the usual. We already limit losses by selling credit spreads rather than naked options. But insurance is extra protection bought at the time the original trade is made. It’s a VERY early adjustment.

Today, the discussion is concerned with thinking ahead. The idea is have protection in place – but it will only be of value if we make an adjustment (as described above) to the original iron condor (or credit spread). The idea is to spend a small sum of cash for protection – protection that is not yet needed.

I want to repeat for emphasis. This is not traditional insurance. This ‘insurance’ trade will not do much good until it is time to make an adjustment. If we never make that adjustment, then the premium paid for the insurance will have been wasted. However, that should be a happy result because ‘no adjustment’ means that we earned top dollar for our original iron condor trade.

A point to consider:

More conservative traders may like the idea of accepting less for the biggest winners and being in a more comfortable (less risk) place if and when trouble arises. Such traders may find this type of insurance to be worthwhile. Please give some thought to this decision, It is going to affect your overall profitability.

Let’s look at an example, using current market prices.

The data under “Market scenario” represents today’s Greeks
The date (to the right) under “Custom Scenario” represent the numbers with RUT @ 540 on 9/7/2011

Figure 1. Greeks for current and future scenarios


Example

    1) As part of an iron condor, sell 5 RUT Oct 520/530 put spreads. The 530 put carries a -16 delta, with an implied volatility of 56%. Midpoint: $1.40. Sell @ $1.30.

    Figure 2



    2) Also Buy 2 INDX 450/460 P spreads as the ‘protection in advance’ spread. It is acceptable to buy the 460/470P spread (at a slightly higher cost) as an alternative. We know that it is currently too far out of the money to do us any good now. However, if forced to make an adjustment later, it will come in handy.

    Looking at a quote screen (again, it’s after hours and not 100% reliable), the bid/ask for the Oct 460/470P spread is -$0.40 to $1.70. Midpoint is $0.65. Estimated purchase price $0.80 to $0.85.

    NOTE: If it seems ‘wrong’ to pay so much when we are collecting only $1.30 for the 520/530P spread, consider the 450/460 P spread instead. You may be able to buy it for $0.10 less.

    Figure 3


    How do we chose which spread to buy? Look at the delta of various options – on an estimated a future date – when RUT may be trading near 540. Why 540? Because that is our adjustment point.

    Looking at figure 1, we can see that (set of data in the right hand half of the table) the 440 put carries a 15 delta and that we would be selling the 430/440 put spread as part of our ‘roll down’ adjustment strategy.

      This is important when it comes time to make the trades. You may decide that the cash out of pocket cost to roll is too high. There are two ways to solve this problem. The obvious is to abandon this adjustment method. The second is to roll down to a put spread that is not as far out of the money. Perhaps a put spread with a -20 delta. This gives you extra cash, but increases the chances of being forced to exit (or make another adjustment).

      This is something you must know in advance. If you adopt this modification, then the put spread that you buy for protection must have strike prices above 460. [Although you cannot see it in any of the charts, if RUT is 540 on Sep 7, and if IV is unchanged, the 460 put has a -19 delta and it’s likely that you would be selling the 450/460 spread. For that reason, when you plan ahead, you recognize that your ‘protection spread’ should be the 470/480 or 480/490.

      There is nothing magical about the two-lots of protection that I bought. You may decide to be more, or less, aggressive when it comes to buying insurance. This is not a well-studied strategy and, as far as I know, there is not good set of data to tell us how effective this play would have been.

    3) Assume it’s 19 days later, Sep 17, 2011.

    4) Cover 5 RUT 520/530 put spreads. Estimated cost: $3.80 to $4.00 each

    5) Roll by selling 5 RUT Oct 420/430P, collecting approximately $1.25 [This assumes the 15-delta put spread is selling for nearly the same price then as it is now. Some time will have passed, but perhaps IV will be higher, increasing the premium we can collect.

    The spread requires payment of a debit near $2.60. If you prefer to pay a smaller debit, it’s okay to sell a put spread with a higher delta (as discussed above).

    This is a risk picture of the new position: Long two spreads and short 5.

    Figure 4

    If that position is too conservative, you can consider unloading the insurance. That cash reduces the cost of rolling the position to farther OTM strike prices.

    Figure 5


    The Numbers

    When we make the original trade, the maximum loss is 5 x $870 (we collected $1.30 for a 10-point spread), or $4,350. The maximum gain is 5 x $1.30 or $650.

    If we buy two spreads at $80 each, the maximum gain is reduced to $490. That represents a reduction of 25%. Then consider that we are probably not going to try to collect every penny of that maximum profit, and the percentage decline is even steeper.

    So what is there to be gained by buying this insurance?

    a) The maximum loss for the original trade is reduced. But this is not important because we are not going to hold until the maximum loss is reached

    b) The trader often likes the idea of making one adjustment, rather than exiting the trade. Because owning the extra spreads makes it more attractive to make the roll (potential future losses are reduced because the trader owns the insurance spreads, the trader may discover that he/she prefers the roll – now that is is less risky than it would have been without insurance.

    This trade idea (thanks Dmitry) is mentioned primarily to illustrate the versatility of options and to demonstrate that a trader can find many ways to reduce risk – at a reasonable cost. And this trade is variable: Change the quantity, change the strikes, choose a different expiration month. You can even choose something other than a debit spread as the insurance play.

    The goal in today’s post is to encourage you to think about the idea of owning OTM options as insurance against an adjustment. When we thin of insurance, it is always against the original position.One more thought: Using calls will make the whole process look and feel better. Those OTM call spreads will be less costly than the OTM put spreads discussed here – because of volatility skew.

6 Responses to “Track That Trade Aug 18, 2011. Preparing for an adjustment”


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