This article was roughed out prior to the May 6 debacle, but you can bet I was glad of my put insurance that day. So were many other traders who had it.
Probably most options traders understand that a primary purpose of options is to serve as insurance. That was also a primary driver for their invention. Those holding stocks wanted insurance against a fall in the prices of the stocks they held. Puts provide that insurance. A restaurant chain that served corn on the cob with every meal may have wanted to insure against a rise in corn prices. They may have bought corn futures or corn options to ensure against rising corn prices.
Although I'm making efforts to diversify my portfolio strategies these days, the primary strategy I use remains the iron condor. As mentioned in another recent article, the risk/reward scenario for an iron condor is lousy, but there's a tradeoff. The probability that the trade will be profitable is quite large. (Don't tell that to most iron condor traders over the last two months, but that's the theory, anyway.)
As an iron condor trader, I like to have some insurance against adverse market moves. At the moment my trade is filled, I most often like to insure my portfolio against a disadvantageous overnight move. I almost always spend about 10 percent of the credit I take in on out-of-the-money puts that I buy as soon as my iron condor trades are filled.
Why puts? Why not calls or both puts and calls?
First, let's think about the reason I buy those puts. My primary fear is a sharp sudden move that occurs overnight, so that I have no way of protecting my portfolio other than buying futures or selling futures overnight. Other than the news that aliens have landed on earth and are awarding each of us a couple of million dollars and healing those with cancer, I can't think of an overnight occurrence that's going to send prices through my sold call's strike overnight. I can unfortunately think of several scenarios that could send prices through my sold put's strike overnight, scenarios that I don't even want to name.
Of course, 10 percent spent on extra puts is going to cut down my average earnings and isn't going to keep me from a loss in such a situation unless markets pass up both strikes and keep going far below them. However, put insurance can be surprisingly helpful in situations like those experienced on May 6, when markets gapped down and fell hard even before the bottom fell out. The put insurance I'd bought just the previous day was to explode in price on that day. Did I anticipate May 6's events on May 5, when I unluckily opened a new iron condor? No, but I'm glad I'm in the habit of buying that put insurance as soon as my iron condor order filled.
I'm buying put insurance at the outset because when markets fall, they tend to fall hard, with volatilities rising sharply, especially in the out-of-the-money puts that everyone might be scrambling to buy in a sharp downturn. If I had waited to buy those puts until I really needed them, they'd likely be so expensive that they wouldn't hedge as effectively against mounting losses. What I need is something that will slow down a quickly accelerating loss long enough that I can do something with an adjustment or else just exit the trade. For example, the put that I bought for $8.20 on May 5 was priced at more than $20.00 at one point on May 6. When markets had opened and started dropping, moving the delta on my sold put's spread to -16.00, I'd bought another put to help hedge price-based movements, fortunately before the floor gave way. Still, that second put cost $17.40, even though I'd bought it before, not after, the floor gave way. If I'd waited until the terrible conditions had been created before I bought that first put, I'd have had to pay that much for it, too. This is a real-life example of why it's harder to wait with puts until you need them. By the time you need them, they may be too expensive to do you much good.
However, when markets rise, implied volatilities tend to collapse. Although exuberant buying of out-of-the-money calls will inflate the call's value a bit, the effect isn't the same. Let's consider a hypothetical 20-contract RUT JUN iron condor established on April 29, 2010. This is not a trade gleaned from my own trading. Using commissions of $1.50 per contract, one calculator estimated that the trade would have resulted in a total credit of $2,510 after commissions. Let's suppose in this hypothetical trade that I elect to spend about 10 percent of that on the purchase of an insurance put. I can't always find a put that's priced at exactly 10 percent of my credit taken in, of course, so that "about 10 percent" tends to be 8-12 or so percent in real trading. For example, I could have bought 1 long 360 JUN put for $2.10. After commissions, that would have resulted in $2,459.50 left in net credit, with a total risk of $17,540.50.
What would have happened if the RUT had dropped 20 percent, to about 590, in two weeks? An OptionsOracle Profit/Loss Chart shows that the expected loss without the protective put would be about $4,600. With the protective put, the chart shows that the theoretical loss wouldn't be much different, being about $4,500. However, if the implied volatilities rose only 2 percent during that drop, from almost 29 percent to 31 percent, the theoretical loss would be dramatically lower, closer to $2,100. We saw how quickly volatilities popped on May 6, so we can only imagine that the protective put might have been even more protective!
Theoretical P/L Chart of Iron Condor Position with Protective Put, after Two Weeks with Higher Implied Volatilities:
Let's start over with our hypothetical iron condor, and imagine that we're not buying a protective put but instead are spending a similar amount on a protective call. For example, let's examine what would have happened if we had perhaps bought the JUN 810 for $1.95. Then imagine that by two weeks later, the RUT had climbed to 761. Why 761? This is about the place at which uninsured iron condor would experience the same $4,650 loss as we saw in the first experiment. This is due to the fact that it's harder to get premium on the upside and the call spread is frequently closer to the action than the put spread when the trade is initiated.
With the long call bought at the time the trade was initiated, the trade is down . . . ta da . . . about $4,550. That's not much protection, and, in fact, the loss didn't even decrease by the amount spent on the protective call. What if the implied volatility had decreased 2 percent during that climb? The loss has actually increased, to about $6,050. This is likely due to effect that both a decrease in volality and the passage of time have worked against the extra long's ability to hedge the trade. Moreover, the long calls are probably not escalating in price as quickly as the short calls. In addition, puts don't tend to lose their value when they're out of the money as quickly as calls do.
These are just theoretical calculations and many factors might result in a different outcomes in real-life situations. I do buy long calls to hedge upside risk when markets climb too close to my sold calls, but I do so at the time they're needed rather than at the time I put on the trade. That typical decreasing volatility in a rally means that I can usually wait to do so, although I may buy extra longs sooner or later depending on the market conditions.
To reiterate, I don't expect an insurance put position to protect me from losses. I do hope that under most market conditions, even a hard drop, they will slow the loss down enough that I can make adjustments or get out of the trade entirely without being slaughtered. The insurance I added to my iron condor on May 5 in fact did that.