I’ve previously discussed the idea of buying extra options (calls, puts, or strangles) – not in an effort to earn a profit – but as protection for an option portfolio that loses money when the market undergoes large moves.This is something that iron condor traders ought to consider.NOTE:I’m not saying everyone should buy such insurance, but every iron condor trader ought to be aware that such insurance is available.
Today I’ll describe an alternative method for buying protection. This method is not ‘better,’ but it’s less costly to make the trade.
1) Buy OTM puts.
2) Sell OTM put spreads.
Sell more spreads than you buy puts – often 5 x 2 or 3 x 1.The lower the ratio, the better your portfolio is protected.
The cost of this transaction ranges from a small debit to a credit.The idea is not to pay much cash, and if possible, collect cash.
Use position analysis software provided by your broker to be certain the risk profile indicates you have enough protection.You may be forced to trade the combination at a reduced ratio to obtain sufficient protection.
The options you buy expire first and if they become worthless (as they will most of the time), then you are short some unhedged put spreads. If far out of the money, buy them back cheaply ($0.25or perhaps a bit more).The cost of repurchasing these spreads is the cost of the insurance (subtract any cash you collected from the original trade).This is pretty cheap insurance.
But, if the spreads are not very far OTM, then you are in a poor spot.That’s the big risk of owning this type of insurance.
If the market has made a big move and your long options move far into the money, you should make more than enough by owning these extra puts than you lose on the put spreads.This profit is used to offset all or part of the losses associated with your iron condor positions.
Example:Here’s one sample that I initiated two days ago:
Bought RUT Mar 340 puts
Sold 3x as many RUT Apr 350/360 put spreads
Cash collected: $0.15
I don’t expect to earn a profit from this spread, but if the market undergoes a rapid decline, I’ll earn a profit.If the Apr spreads are available @ $0.30 any time before Mar expiration arrives, I’ll cover them.That results in a loss, but it’s very inexpensive insurance.If necessary, I’ll manage the risk when I lose the protection of the March puts.
There are different ways to play this.Different ratio.Strikes that are closer together.Months further apart.The advantage of buying nearer-term options: they cost far less (in dollars, not in IV).
Warning:This is not a good idea as a money making trade.It’s strictly for insurance.
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