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Wednesday, May 6, 2015

Getting ready to defend. No reason to panic.

With the recent sell off in the RUT index it is a good time to reflect upon our strategy in order to better understand it. Only a solid understanding of its potential and weaknesses will make us feel truly confident in what we are doing.

This is the business of selling options. You know, where you have a lot of winners for a while until "that day happens" when you lose it all. That's what happens to most options sellers and that's why you sometimes cannot avoid that feeling,......the dread,.....the terror,...the what ifs. So, here I am and hopefully with this analysis I can shed some light on how all these positions can be managed conservatively in order to minimize damages and what's more interesting, in order to be able to quantify them way in advance. Knowing the magnitude of your losses in advance kills the panic, because you simply know how bad it can get, unlike the trader who doesn't know what the magnitude of his losses will be by the time his position needs to be adjusted and therefore gets nervous and makes regrettable decisions with his capital.

First, a chart of the Russell Index and the current positions represented by horizontal yellow lines. That's where I don't want the index to go:

(Click on image to enlarge)

Let's now zoom in a little bit:
(Click on image to enlarge)

These are our babies:

May RUT 1100/1110/1330/1340 unbalanced Iron Condor
99% probability of success and expires next Friday. With RUT priced at 1219 today, I'm not concerned.

June RUT 1130/1140/1340/1350 unbalanced Iron Condor
A little more than 6 weeks to expiration and I might need to defend the Put side here.

Now, notice how the positions are fairly similar in terms of strike prices. However, the probability numbers are entirely different due to the fact that there is different time to expiration for each case. This is good because you avoid having to defend two different positions at the same time. I might get concerned about the June position if RUT falls below 1200 because the market has plenty of time to hurt me from now until June expiration. But will I lose my sleep over the May position? Absolutely not. So, how do we move forward?

Ok, the 1140 short Put of the June unbalanced Iron Condor will reach 30% probability of being in the money if RUT hits 1195 or so. It depends on how fast it gets there, if it falls too fast the 30% probability will be reached sooner, around 1200.

Now, if the 1130/1140 spread needs to be adjusted, it will be worth around 2.20 debit by that point. That would be $440 debit to close it because we're playing 2 of those spreads in the model portfolio. The initial credit received for the whole unbalanced Iron Condor was $225. Therefore $225 - $440 = -$215. That loss is less than 2% of the portfolio.

As usual, I would deploy a new Put spread farther out and that would be the 1060/1070 spread with June options which will be worth around 0.60. Deploying 2 of those spreads would bring a new $120 credit and then RUT would need to fall 200 points measured from the recent peak of 1278. The final result would be $225 - $440 + $120 = -$95. Less than one percent of the portfolio, and this is assuming we do not increase position size on the adjustment. No reason to panic. This small loss would be mitigated by the May position that expires next Friday and will be a full winner. Overall, the portfolio wouldn't feel the dent.

That's the defensive part of the game.
Now, in terms of offense, new positions to add for the counter attack.

Number of stocks above their 20 Day Moving Avg is 30%, right there about to enter extreme pessimism territory.

McClellan at -188 is already oversold.

RUT's stochastic oscillator is at 15 point something, so I would normally sell a RUT credit Put spread, but, because I already have two of them on and because one of them might need to be defended I will ignore this signal to not increase my risk excessively.

SPX's stochastics on the other hand is not as oversold as RUT. Stochastics still above 40 and the SPX index has barely fallen 2% from the recent peak. So, I am willing to sell Puts on SPX but not right now. My plan with SPX is the same I outlined during the Weekend Analysis. I need for SPX to fall a bit more, then I will sell Puts around 1850 - 1860 using June options. If I get to do that the June balance will likely be positive even with a losing trade on the RUT put spread.

We'll see how it all unfolds. This is the first real challenge in 2015 and it was about time. Let's embrace the challenge. It's not time to panic or curse the credit spreads selling business. See you in a few hours.

If you want to learn how to accurately estimate your losses in advance, your future adjustment points, future credits to receive and much more, consider acquiring LTOptions, my options trading system revealed to the last detail.

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  1. This is a very good lesson on how to get out of a threatened position without losing too much money. Thanks for sharing. I have a similar plan except I will hedge my position before I close it. I will hedge with a debit spread if the delta is around 20 and will close the position if the delta is 30.

    1. As long as we consistently defend early, the game is not dangerous. It might be a bit frustrating yes, when you defend early and later it turns out your original position would have never ben penetrated. But it's the sacrifice we make in order to avoid large losses. I like your idea of a hedge prior to adjusting. Sounds interesting. Now I want the markets to fall 5% today to see you implementing it :)