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Options: How to Insure Against Risk


Over-confidence remains a killer.

As I've discussed previously, when you trade options, managing your positions is far more important to your overall profitability than choosing the "best" strategy. More money is lost by mismanaging risk than is made by adopting one specific strategy over another.

At the moment, I admit to being undecided about how to proceed with my trading. I still own some RUT June positions (they began life as iron condors, but most of the put spreads have been covered at $0.25 and $0.30). One thing I know for certain is that the unidirectional markets of recent times have made the iron condors I chose unprofitable.

My methods are designed to profit from markets such as those we encountered recently (a huge down followed by a huge up). Owning pre-insurance would've solved all my problems. But I strayed, buying some, but not nearly enough insurance.

Discipline is still the name of the game for traders and investors. And over-confidence remains a killer. I'd been doing well and became too confident. Thus, I backed off when buying insurance. Somehow I didn't believe I needed a "full load" of insurance over the last 2 months.

A recent comment by reader GMG made me glad to see that those methods worked for someone else: "Using pre-insurance was a key reason that I expect to end up with a (meager) profit. The April rally would have stopped me out long ago without those extra calls I bought."

Recognizing that pre-insurance (the purchase of extra options) works wonders when the market makes a sustained move in one direction, and noting our profitable (if hypothetical) diagonal back spread (click here for latest update and click here for original post), makes me want to own extra options. The steadily decreasing volatility makes that strategy less expensive to adopt, but one not-to-be-ignored risk is that IV will continue to decrease, and these spreads are rich in vega.

Another of my favorite ideas for providing insurance for iron condor positions is to open an insured half-iron condor. In other words, sell a put spread and own extra puts, or sell a call spread and own extra calls. For anyone who believes the market may re-test the bottom, this is a decent proposition. If the markets reverses big-time, those extra puts will work nicely. If the rally continues, there's nothing to lose from the put spread - and a call spread may become wildly profitable.

In this scenario, all roads lead to backspread positions. For a dedicated premium seller, it's not that easy to make the temporary change. But one of my premises is that market conditions change and a successful trader must be flexible.
Position in RUT.

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