When Options Positions Go Bad a.k.a. *Getting Your Hedge On*

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Someone who commented on my previous post asked the following:

How do you manage the gamma risk of ICs [Iron Condors] as the market approaches your short strikes?

My Response follows:

First things first (unrelated to the question at hand, but, completely related to the general trading of index options):

Why are you trading the SPX?, If I may ask, And not the SPY?

Do you like giving free lunches to these Chicago pit traders? Actually, I shouldn't be so harsh, I used to trade the SPX options also until I learned that the fills are usually real bad if you're not patient. Reason being: the SPX is still a proprietary product and only trades in the Chicago pit, so there aren't any other exchanges competing for your order, so the Chicago pit basically gets what they want--which is why the spreads are often inordinately wide and fills are usually far from fair value if you don't work the order for while. So your next question might be, "So what, I'll just find the middle between the huge 2.50 wide bid/offer spread I'm getting quoted for my 4 leg iron condor, and enter a limit order for the spread at what my options calculator is saying is fair value and they'll fill me somewhere around that." Good Luck with that. Actually, if you work an order for a while, you'll probably get a decent fill--still, it'll probably be about 20 or 30 cents off of fair value (if you're trading a spread comprised of several options), but you'll still get filled at a better price than if you try to just get a position on in 5 minutes. But the problem REALLY arises when you want to trade the SPX options in a fast market. What if the market is moving swiftly and you don't have time to work an order for 30 minutes so you can get a fair value fill? You know what you get?--you get to take what the SPX pit gives you, which will be a horrible bid and equally ugly offer. Now, I usually always trade the SPY options. Eventhough you have to trade a lot more contracts (resulting in more commission--this is the only downside to trading the SPY over SPX) in order to trade the same dollar "size" of the SPX, the SPY options are quoted only about .10 wide, and the near the money options are often a nickel wide with fair value being somewhere within that nickel wide bid/offer. No need to mindlessly work orders for 30 minutes, like often necessary in the SPX to get a fair fill. Plus, multiple exchanges will compete for your SPY option trades, which will naturally cause a better drilling down to the "most fair" bids and offers for you. Trade the SPY to get the best amount of edge via fairest price possible.

Now onto the nuts and bolts of the original question:
How do you manage the gamma risk of ICs [Iron Condors] as the market approaches your short strikes?

3 immediate ways come to mind, and I use all of them--depending on the total structure of my portfolio (more on portfolio structure at the end of this post):

1) Sell some out-of-the-money credit spreads to hedge the directional delta/gamma exposure. (ie: get more delta neutral, and benefit from more time decay in the process.)
For example, using the S&P from today that closed around 1304: If you are short the SEPT SPX 1320/1340 call spread as a part of your iron condor, you have probably been feeling some pain the past 5-7 days as the market slowly melted upwards. If I was in this situation (and STILL haven’t done anything about it until today) I would probably have sold a few SEPT SPX 1270/1260 put spreads at today’s close to hedge my deltas which are getting more and more negative (a short biased) as the market gets closer to my 1320 call short strike and further away from my Iron Condor’s short put strike. By selling this 1270/1260 put spread I would take in some decent time premium as well. This is a bit more of an indirect way of hedging the additional gamma your options, but it also has the benefit of giving you more daily time decay besides just the hedge. I really like to hedge exposure by selling additional spreads to neutralize things, because it allows me to increase my time decay, while at the same time neutralizing the directional aspect of the particular greek I'm not comfortable with at the same time.

2) Buy some directional butterflies near the short strike of the side of your iron condor going agaist you.
If you’re comfortable filling your options book with a lot of strikes/contracts and you understand how all the options interact with each other, then butterflies are the way to go as they are cheap and they pack a nice reward profile (and insurance policy against your iron condors) if they work. Butterflies really work best when expiration Friday is less than 2 weeks away as the butterfly spread will expand (ie: it becomes worth more than you paid for it—a good thing!) as expiration day gets closer and the market gets closer to the short strikes of the butterfly body. Therefore, if the butterfly gets more expensive as the market nears the butterfly body, align the body of the butterfly (the 2 short strikes in a purchased butterfly) near the strike of your “bad” short strike going against you in your iron condor. Using today’s closing prices (16 days left until SEPT expiration) you could buy the 10-point wide call butterfly with strikes 1305/1315/1325 in the SPX for about 3.00 (its bid 1.90, offered at 3.80—too darn wide—reason again to trade the SPY!!). But, this 3.00 ($300) position can potentially widen all the way to 10.00 ($1000) if the SPX is trading exactly at the strike of the body of the butterfly on expiration day. Obviously, you probably wouldn’t hold it all the way until expiration, but even if it trades to the middle strike during the final week up to expiration it will like get up to around at least $500-$700, which means it around doubles in value which should more than make up for the losses from your short 1320 call if enough butterflies were purchased. The ratio of butterflies to iron condors is up to the individual trader (basically, “how much insurance do you really want?”). Sometimes I just like to buy a lot of them, and take them off incrementally if they profit—What can I say, it’s a “feel thing.”

3) Trade S&P futures contracts intra-day as a hedge against the deltas going against you because of your increased gamma from the near strikes you are short in your iron condor.
(This the most aggressive, but also the easiest to execute, easiest to hedge dollar-for-dollar, and easiest to profit from if you’re skilled at trading short-term breakouts from support/resistance levels). If the market is trending strongly and my short strikes are getting near, sometimes I’ll just aggressively trade breakouts using basically the same amount (or maybe a little more) of emini futures as would equally hedge my SPX (or SPY) option deltas that are going against me. The basic idea behind this is that overbought markets can get MORE overbought (same goes for oversold markets getting more OVERSOLD), and that it’s only a matter of time until the move reverses, or at least takes a breather and that your short strike will eventually be OK. Using the same scenario as in #1, with the S&P currently at 1304, and I have short strike exposure at the 1320 call that I’m worried about, I would be a buyer of the S&P emini on any “breakouts” to the upside and keep profitting on the long futures trades until the market reverses (i know, i know, easier said than done). Determining what defines a “breakout” is left up to the individual trader, as no 2 people are likely to agree on this from both a trading perspective or a risk mgmt perspective. Personally, I find using the previous day’s high as a good breakout signal after the market has consistently gone up (seems like everyone wants to get on the runaway train at least for a little while!)—therefore I’d buy emini’s as the market crossed the previous day’s high and hold through the end of the day—this effectively hedges all your upside risk against your short strike for the whole day if bought on the correct ratio against your short options deltas. I like to be a bit more aggressive with a few of the emini contracts within the trade and sell them as the market trades up into short-term chart resisitance, and then potentially re-buy them if the S&P comes back to retest the breakout point (the previous day high, in the case of this example). Setting stops on these futures trades is also important—the simple stop point is the low of the previous day, but if the range is wide the previous day, then a tick or two below the halfway point of the previous day is usually a good stop that won’t prematurely kick you out of too many trades. Remember, if you lose money on the futures trades, it almost "no big deal" because that means your options book will likely be making money... interesting concept--sometimes I think I'm a better futures trader when I know that all I'm doing is "hedging" so emotionally I'm less attached to the directional aspect of the trade--I would almost consider this too be some good "edge" int he trade, and is why I'm always looking for an opportunity to trade futures around a core options portfolio--Psychologically, it works for me. Incidentally, RARELY will I carry any futures exposure overnight since I really don't want the gap risk associated with a futures contract--If my deltas were really bad, then I might hold a couple, but nothing substantial, and I'd be more inclined to hold short futures contracts than long ones, only because it is very rare for the market to gap up huge at the open, but a huge gap down open happens more often (therefore holding short futures position overnight reward/risk profite is slightly better, than the risk/reward of holding a long futures position overnight.)

General Thoughts on Portfolio Structure
Honestly, 99% of the time, the only time I think of the individual positions as "Iron Condors, vertical spreads, calendars/diagonals, and butterflies" are at initiation of the trades themselves and how they fit the scope of the total portfolio when the trade is opened. After the trade enters the portfolio it merely becomes part of the total portfolio greeks. Butterflies I'll usually trade around as individual positions only if they are coming into play, but otherwise, they are merely hedging the risk of my nearest short strike from the greeks they give my whole portfolio.

As days/weeks go buy, the big thing I'll monitor is how many near month options I have expiring, and how many of those are pieces of calendars or just pieces of iron condors and verticals. If its part of a calendar then I need to try to time/manage around the best opportunity to roll the near month option to next month--that's a real trick that just takes experience. So, basically, I'm not "too concerned" about my short iron condor strikes getting hit, just really concerned about the total greeks of the portfolio. If the short strike getting hit is the reason why my greeks are all screwed up (ie: biggest problem=a delta that is really biased either long or short) then I'll attend to the bad short strike, otherwise, I'll just sell some verticals or buy some calendars/diagonals to give me the greek profile I want to have at that particular moment. Another reason I'm not too concerned about short iron condor strikes getting hit is that in the scheme of my whole options portfolios iron condors are really a pretty small percentage. The P/L swings with ICs are really too much for a huge portfolio that is aimed at achieving incremental revenue. Trading mostly calendars rather than just ICs really dampened the daily volatility of your P/L.

The most important thing I can leave you with is as follows:
The 2 greeks that I really manage my entire portfolio around are delta, and vega, and most of my strategy involved really understanding how my delta and my vega are going to put me in the best position to make money in the market tomorrow and through the next 5-7 day period.

The Basic Playbook
And the breakdown, at the 30,000 foot level, the portfolio would be comprised by options opened using the following structure:

15-20% : Iron Condors/Verticals in the front month
5-10% : Iron Condors/Verticals in the next month out
30-40% : Calendars/Verticals out to a max of 4 months
30-50% : CASH (I always like to have a lot of cash on hand for hedging and damage control purposes, and to exploit opportunities during big market events)

That's my basic playbook... Anything else would be too complicated to type into a blog (Like how I choose my strike prices for my ICs/calendars/diagonals/butterflies, how and when I roll my front month calendar options, and how/when I choose to close out my ICs--almost NEVER let them expire worthless, by the way!)

Whew... that was a long post...

Up tomorrow, hopefully I'll have time to update the tracking of my directional options trading system.