You might be more naked in your option positions than you think you are.

For the November cycle, I put on a 25-contract SPX iron condor. The other day, I had closed out the 25 contracts of SPX bull put spreads, locking in some profits, and was watching the position deltas on the remaining 25 bear call spreads. I don't like to end the day with the absolute value of a 25-contract SPX iron condor position too much above 80. It's just a personal preference. Experience has taught me that those positions can get into trouble rather quickly when the absolute value of the position deltas grow much larger than 80. That's especially true in these market conditions, when the SPX can gap higher and run up a quick 10-20 points in the first few minutes of trading. Back three or four years ago, I wouldn't have had this particular mental cutoff, as the SPX didn't tend to gap as much.

On this particular day, the SPX wasn't moving that much in the afternoon, but my position deltas were getting more and more negative. They were quickly approaching that level at which I like to level out some of the delta-related price risk before the day ends.

If the SPX wasn't moving much, why were my position deltas getting more and more negative? Volatility was changing on that afternoon. Jim Bittman tells us in Trading Options as a Professional about the effect of volatility on the delta of options. He provided a general rule that has always helped me quickly remember how volatility impacts delta. Absolute values of "[d]eltas change toward +0.50 when volatility increases and away from +0.50 when volatility decreases," he states on page 98. The deltas on both options, the sold and the bought ones, should have been changing. You would think that since they're both changing the same direction, the extra negative deltas produced or lost in the sold calls would have been offset by the extra positive deltas produced or lost in the long options. Didn't happen that way.

Let's think about that a little. When volatility changes, the deltas of at-the-money options aren't going to change much. The deltas of out-of-the-money options are perhaps going to be impacted more visibly. And, perhaps, the further-out-of-the-money those options might be, the bigger and more visible the impact. On the afternoon in question, the implied volatilities of the options were dropping as the SPX sat still. If that were happening, perhaps the difference in the short deltas from my closer-in sold options and the long deltas in my further-out long options was changing, too.

In fact, overall, implied volatilities had been dropping over a three-day period, and the differences in the deltas of the two options were widening as volatilities dropped: from a difference of -2.38 per spread contract two days previous to that afternoon, -3.21 one day previous, and -4.87 at the close of the afternoon in question. By that close, I had long adjusted the position to level out the deltas. Otherwise, the position would have closed the day at -4.87 x 25 = -121.75 deltas, theoretically losing $121.75 for each point the SPX might gap up the next morning.

I was--or at least, the position was--more naked than I had been several days earlier. Falling volatilities had rendered that hedging losing position less effective as a hedge. Other changes can rip away that hedge's protection, too. Bittman has an explanation for how time impacts out-of-the-money options. "The absolute value of deltas of out-of-the-money options decrease toward zero as the expiration approaches" while that of at-the-money options stay steadier (94). Presumably, the further OTM an option might be, the faster the absolute value of its delta might decrease toward zero. Again, the further OTM hedging long call position might have been shedding long deltas more quickly than my sold calls were shedding short deltas. My hedge was as effective a hedge as it had been earlier in the position.

The interactions don't always occur in just that way. The changes can depend on the skew of a particular month's options or due to the option's strike being more or less "popular" among option buyers or sellers. For example, if the SPX were shooting higher and traders thought it might be aiming for 1200, they might be buying up those OTM 1200 calls like hotcakes, ignoring the strikes just above and below that nice round 1200 number. Buying pressure would increase the price of that option in relationship to the surrounding ones, at least temporarily. The interaction of volatility and time can prove confusing, but you don't have to be confused. Here's the point: traders need to keep checking the state of their clothing . . . and their hedges. It may be necessary to roll a hedging long position in closer or out in time so they stay as effective as they were earlier in the trade or when volatility was different.

Of course, some traders never intend the hedges to do any actual hedging, and they have no intention of rolling them. These traders are merely using the hedge as an offsetting long that lowers their maintenance or margin requirements. Some iron condor traders don't care what the hedge looks like on paper because they know their maximum possible loss when they get into a trade. However, this iron condor trader doesn't want to suffer that maximum loss.

That delta level I mentioned earlier--an absolute value somewhere around 80 deltas for a 25-contract iron condor--isn't some magic number I devised or back-tested for years. It relates to my own comfort level only and shouldn't be taken as some kind of guideline for other traders. It's just the level at which I personally start getting nervous. These days, after a big loss in March, I tend to overhedge and overtrade a bit, so I'm not suggesting that you follow my neuroses and start madly increasing your hedges automatically when the position deltas have an absolute value of about 80.

What I am suggesting is that you keep an eye on the value of your hedges, especially as time passes and with changes in volatility. You may be walking around more naked than you think.