Gettin Your Hedge On--Part 2

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I forgot to mention one thing in last nights post about suggestions to hedge a short strike gone bad:

Here is a 4th idea, and following it, a couple reasons on how NOT to get scared out of your short strikes too early:

4) Another suggestion is to trade directional calendars/diagonals to get the delta you need to offset your Iron Condor short strike problem.
Diagonals are cool in that a put diagonal can either have negative delta associated with it OR positive delta associate with it depending on the strikes you choose (same goes for calls). Using the same example as before: assume your short 1320 call is causing you problems resulting in your being short too many deltas and you want to get more delta neutral. One of my previous suggestions was to just sell some put verticals. But, say, you do not want to sell put verticals in this cheap volatility environment (low VIX), and you would rather BUY cheap volatility (always good to buy low, sell high, even when your talking volatility). Buying diagonals is a way to buy cheap volatility, and if you choose the strikes of the put diagonal properly you will get the positive deltas you need to offset your negative delta situation.

The directional delta you get from a calendar/diagonal spread will not be as much as you get from a vertical spread (which means you’ll have to trade more total spreads when doing the calendars if you want to create the same amount of delta), but it does fall in line with not only trading price, and including the current state of volatility as component of you decision making process of hedging.

In the end, choosing between verticals and calendars/diagonals when hedging comes down a lot to personal preference, including total amount of buying power you want to spend on the hedge, and how long you really think you’ll want the hedge in place (if you think that you only want the hedge for a week or 2, and don’t want to deal with the overhead of the hedge after that, you might not want to get your self into a 3 month calendar spread with you hedge-although I would argue that you could just roll the hedge into a real position after its hedging purposes are complete-but that’s a whole other ball of wax.).

Do Not Jump Ship Too Early

A huge point to also discuss is the idea of getting scared out of your short strike too early:

1) It is LESS likely for you to get scared out of 1 short strike if you are managing the whole portfolio rather than just one position.

2) If you are short an iron condor, or even just a vertical spread, the short strike actually has a much higher probability of being touched before expiration than you might think. The brokers I trade with at http://www.thinkorswim.com/ actually have a neat probability calculator built into the options quote monitor to show people that you almost have to EXPECT YOUR SHORT STRIKE TO BE TOUCHED, and to understand this and not worry about this (of course, again, this is easier to not worry about when you are trading a portfolio of options rather that just individual spreads.)

A calculator is not needed to predict the likelihood of your short strike to be touched before it expires. For out-of-the-money options it is actually just about 2 times the absolute value of the delta. To see what I am talking about, look at the Think Or Swim trading system screen shot that I just took for the SPY chain (the pic is at the top of this post, click to enlarge) to compare the deltas of the strikes to the calculated probability of touching that particular strike prior to expiration.