Concerned about Downside Risk?

Kim · September 7, 2012

From Mark Wolfinger, Options For Rookies

Mark,

I enjoyed your site a great deal. Very clear and easy to understand.

I have had good success in selling RUT and SPX short call spreads and I also do a smaller quantity of short put spreads. I am concerned about losing a big amount if the market moves suddenly. I also want some hedge to protect my long positions.

I start with 15-delta positions, 20-point spread width. I roll them to safer strikes in next month if the index comes within 20 points of the short strike.

Is this a good plan? Am I rolling too soon? Could I get run over if the index moves 40 to 50 points in one day as has happened in the past? I do fairly large positions, like 100 SPX contracts.

Would appreciate your thoughts.

K

Hello K,

Thanks for the kind words.

The obvious and most simple answer to cutting risk is to reduce position size. Yes, I understand that is not the solution you seek. So let’s consider alternatives.

Rolling Down and Out (to longer-dated options that are farther OTM)

Yes, your plan is viable for the right trader when used judiciously. I do not recommend adopting this strategy every time the position becomes threatened.

If you adhere to your plan, it will serve your needs MOST OF THE TIME.

I must mention that the general concept of ‘rolling down and out’ is not one that I believe is efficient. Too often the trader finds himself owning an uncomfortable position – after the roll.

If you ask how that can happen, the easy answer is: The trader who is unwilling to accept the fact that the position has already lost money; the trader who is not willing to exit the position because it would lock in a loss – even though the position has become too uncomfortable (risky) to hold; the trader who believes that owning a position whose options are father out of the money is ‘safer’ will always elect to shift current risk to a more distant expiration date with those so-called ‘safer’ options.

Those farther OTM options are not safer. Yes, there is a reduced probability that the position will turn against you and thus, there is a reduced chance of being forced to make yet another adjustment. However, the potential loss is now larger than when the trade was initiated. Why? Unless the roll is made for a cash credit, more cash has been invested into the position and the maximum possible loss may be higher if the situation turns ugly.

To collect that cash credit, it is often (not always) necessary to take one of two actions – neither of which is desirable.

To get extra Premium, the trader may feel obligated to sell a spread with higher-than-desired delta
To generate extra cash without selling higher-delta spreads, it is tempting to sell extra spreads

Note that selling extra spreads is acceptable when the ORIGINAL POSITION was less than the trader’s usual size. However, as you are aware, things can go very wrong when a second big move occurs – after the position has already been rolled once. For traders who prefer to roll out one or two months (instead of rolling down within the same expiration), that can present an awkward situation.

Why?

If you prefer to trade short-term options, the second roll may give you an uncomfortable position to manage because the new position may have a lifetime that is much longer than your original trade.
You may discover that the premium you can collect for the new position is not good enough to compensate for the risk. This is a real possibility when you are rolling to higher strikes in a rising market characterized by falling implied volatility
You may be opening a new position that you are not anxious to own

Bottom line: Rolling out – as a planned adjustment, rather than as a move that is 100% voluntary – is fraught with possible problems (as listed above).

Are you rolling too soon?

There is no good answer. For me, it is a very reasonable plan. Twenty points OTM is too close for comfort for some traders. Please keep in mind that market conditions change an what feels right today could easily become a losing strategy when things are different. I remember that in the 2008/2009 market, I found that adjusting when 30-points OTM was too aggressive and that cutting risk earlier was necessary. Remain flexible.

The term ‘too soon’ is a measure of your risk tolerance and how uncomfortable you are with the position. You never want to hold to the point of being nervous, afraid, or especially FRIGHTENED. We should adjust before feeling that way. If 20-points satisfies those conditions for you – then it is a good place to adjust.

20-point spreads

One piece of advice: I do not like the idea of trading 20-point spreads – if the reason for choosing them is to reduce commissions. The 20-pointer is really the same as trading each of the two adjacent 10-point spreads. I suggest trading only the one you believe makes for the better trade.

If you like both and want to trade both, then yes, the 20-point spread is the correct play. But if you truly prefer one, there is no reason to trade both. You can afford to sell twice as many of the 10-point spreads – for essentially the same risk.

Size

You do trade good size for a retail trader. Have you ever thought about trading closer-to-the money iron condors (Yes, they can be off-balance ICs as you are currently using)? I do not want to talk you into this. I am only asking if you thought about trading them. There are benefits.

These CTM (close to the money) iron condors are not for everyone. That is why you must not jump into them without further discussion. These positions would be adjusted by rolling DOWN instead of rolling DOWN and OUT. Most importantly, the adjustment would come far later – perhaps when the short option is ATM, or slightly ITM.

Run Over

Yes, you can get run over. Especially on a gap opening. However, that is one of the risks associated with any premium selling strategy. You can buy some black swan protection by owning a small number of FOTM Puts. Should that market disaster occur, these puts would explode in value due to a big IV increase. They would expire worthless most of the time – just as does any insurance policy.

The problem with this is that you cannot gain the same protection to the upside. Those FOTM calls would not explode in value. But they are less costly to buy, and do provide some protection on the big move.

DO NOT BUY longer-term options for this strategy – unless IV is quite low. You want to be buying options with GAMMA, not options with VEGA. In other words, I’d rather own Sep puts that are 80 points OTM than Jan puts that are 120 points OTM. But that is ‘style.’ If you decide to do this, you can figure out which puts/calls you would like to own. Just consider it insurance for your business. That means it is on the expensive side. Ten puts ought to be plenty. And perhaps an equal dollar amount of calls. Disclosure: I used to buy insurance, but have not done so in a long time.

Alternatives

Another possibility is the pre-adjusted trade, such as the broken-wing iron condor. Less profit potential, less risk.

Another choice is to trade only 50 SPX and try to find another index that is not 100% correlated. I agree that this may be difficult to find. Trade European style, cash-settled indexes, if possible.

Does any of this appeal to you? There are really a significant number of modifications you can make to your trading. Almost all are risk-reducing, and thus come with a smaller potential reward.

NOTE: IF you are trading front-WEEK options, things are very different and much of what I suggested above is not going to work. Such trades are high-risk/high reward and the best way to play them is in smaller than your usual size. Making four or five forty-lot trades every month should more than compensate for the fact that each trade is less than than 100 spreads.

Good trading

Mark Wolfinger

Options For Rookies