Paul gave me these screenshots and asked me to finish the analysis. Here goes:
Just before noon on Friday, Paul bought the 24SEPT 4425/4400/4375/4350 put condor in $SPX. He paid $3.00.
The Put Condor has an especially effective risk profile. The position carried just -2.67 deltas, and had a $300 max loss and a $2,200 max profit at expiration. The delta (directional) risk is primarily measured horizontally. By raising the vertical component of the position (i.e., steepening the walls of the condor by rolling the long options inward), Paul can remove original risk from the trade without a commensurate increase in directional delta risk.
The risk:reward of the original position is over 1:7. Already great. Below is the adjusted Condor after narrowing the spread by $10 ($5 on the debit side and $5 on the credit side). After adjustment, the risk:reward is now over 1:8. Delta is reduced to -1.94.
Each of the following risk profiles show the adjustments that were available prior to the close on Friday. With these adjustments, Paul could’ve reduced or eliminated the overnight/weekend risk prior to Friday’s close.
Here is the adjusted Condor after narrowing the spread by $20 ($10 on the debit side and $10 on the credit side). Risk:reward is 1:11. Delta is -1.30.
Here is the adjusted Condor after narrowing the spread by $30 ($15 on the debit side and $15 on the credit side). Risk:reward of 1:17. Delta is -0.76.
And here is the adjusted Condor after narrowing the spread by $40 ($20 on the debit side and $20 on the credit side). This is the zero cost (i.e., zero original risk) Condor. It’s delta is just -0.33.
As you can see, these adjustments progressively remove risk from the position while also reducing directional risk (flattening deltas). We “buy” this reduction in risk by giving back some of our theoretical max profit. But with each iteration, the percentage of theoretical max profit we give back is less than the percentage of actual risk that we remove from the trade. In other words, each iteration improves our risk:reward.
Also note that we accomplish this improvement in risk:reward without narrowing the max profit zone of our spread (the space between the short strikes). So although our theoretical max profit is reduced, our statistical probability of achieving that max profit remains unchanged. Pretty cool. (Those interested in a homework assignment can compare the results of applying this same hedging technique to a butterfly spread.)
Is there a downside? In fact, there are two — one that arises immediately and one that develops as the trade progresses:
The first downside is that we have slowed the trade down a lot. If our primary goal is removing risk from the trade, then slowing the trade down isn’t really a problem. It just means that we are less able to capture additional profits from near-term price behavior. Because of our reduced delta, we will get paid less for any directional move in our favor. And because these adjustments reduced theta as well, we will also capture less time value if price sits in our profit area in the near term. This in turn increases the odds that the stock moves against us before theta has had a chance to build much additional profit for the trade.
The second downside is that the hedge that made our trade slower in the near-term will make it faster as we approach expiration. By narrowing our vertical spreads, we steepened the walls of the condor. As time passes, our T+0 line conforms to the expiration graph. meaning the delta will steepen dramatically near our short strikes. This is called gamma risk. And unless the trade is behaving perfectly, that gamma risk will make it unwise to hold the trade into expiry, reducing our odds of realizing that theoretical max profit.
So what do we do with all of this information? When should we hedge, and how much? As Paul has highlighted in recent posts, avoiding large losses is the key to profitability. At the same time, however, the key to outsized profitability is avoiding large losses while also letting your big winners “run.” Hedging can protect you from large losses. But if you hedge too aggressively, it can also cost you big profits. So how do you choose?
Some traders have absolute rules for this. I don’t. Instead, I have a set of four principles that I evaluate continuously when managing a trade. The art of hedging is deciding when the balance of these factors, when weighed together, favors hedging a particular trade. Small books could be written about this, but here is the introduction.
Circumstances favor a hedge when:
- My expectation for the stock has changed. If the stock is performing exactly to my expectations, my goal is to leave it alone as much as possible to realize as much of the upside of my original thesis as possible. But if my expectation changes, I will act as efficiently as possible to bring the trade in line with my changing expectations. This change could relate to the direction I expect the stock to move or the time in which I expect that move to occur.
- I am no longer comfortable carrying my current risk. Even if the stock has moved in my favor, I may become uncomfortable because the stock is not behaving as I expected or because the position hasn’t built enough profit to make me comfortable carrying my current risk overnight or into some micro even (like earnings or a product launch) or macro even (like FOMC meetings).
- I have an opportunity to deploy my risk capital more efficiently. If an existing trade is profitable but is performing slower than I would like, I could hedge it to free up risk capital for a fresh setup that offers better risk:reward or quicker profits.
- My marginal risk:reward is no longer favorable. Risk:reward is not static; it evolves constantly. And it can be analyzed for each component part of your position. Paul’s condor had 25-wide wings. Since $SPX options chain has 5-wide strikes, we can look at each 25-wide vertical in this condor as comprising five 5-wide verticals. Each of those 5-wide verticals has a max theoretical value of 5 dollars. The position will build profit from the outside in (i.e., from the outermost verticals inward). And once most of the profit has accrued in those verticals, my risk:reward for those verticals flips–I now have more open profit to lose in that vertical than I have theoretical profit to gain. When the outer verticals have accrued a substantial majority of their theoretical profits, I will strongly consider rolling the outer long strikes inward, which closes those outer verticals and books their gains.
Paul’s Update: Excellent post by Travis! Point #4 above regarding the mechanics of reducing risk is an especially important one! To see a specific example of what what he’s referring to click on this link to my “Easier Said Then Done?” post. At the bottom of the post is the 09/20/2121 update showing a potential adjustment that I was considering. Check it out!
Questions? Comments?