The US markets are officially off to their worst start in history. Just to set the context, we’ll cut to the summary from Barron’s:

Stock benchmarks fell for a fourth straight week, putting the market on track for its worst January ever. The Dow Jones Industrial Average ended the week down 507 points, or 4%, at 12,099. It has fallen 10% in four weeks, and is 15% off its October peak. This is the Dow’s worst-ever start to a year. How afraid is Wall Street? The S&P 500 is at a 16-month low. Only 11% of its components are holding above their 50-day averages. The bond lunge has forced the yield on 10-year Treasuries to a four-and-a-half-year low near 3.6%.

A word of warning. People are famous for getting the time-honored maxim of trading correct in theory, but backwards in practice: they buy high and sell low. Now, this may not be the bottom of anything, or it may be a short-term bottom that presages a much steadier bear market. But one thing’s for sure: if you got plowed this month and are contemplating “getting out,” be warned that you may be exiting the markets at exactly the wrong time. Remember that a bear market is basically just as orderly as a bull market, but in the other direction - it certainly doesn’t look like this January’s chart month after month! And that’s important to remember, because sometimes people think that iron condors only work in flat or bullish markets, when if anything, the opposite is true: as we’ve written before, the best time to trade iron condors is in the high volatility environments that are typical of bear markets.

We traded two positions for the January expiration cycle, and they were both closed out at effectively their max loss points. Now, if you’ve been following our strategy for awhile you know this is the worst monthly performance we’ve had yet. But rather than sweeping things under the rug or just staying quiet and hoping those losing trades will go away, we’re going to take a hard look at what went right this month, what went wrong, and what (if anything) needs to be changed in our strategy going forward. If you haven’t already read our recent posts on asset allocation and on hard stops, you might want to start there. Not to belabor the point or anything, but if we didn’t practice smart asset allocation and risk management, no amount of strategy tweaks or trading adjustments could ever offer enough protection against losses. So anyway, on to the analysis.

What Went Right

There were a couple features of this expiration cycle that kept things from turning out worse than they did. First, we stayed half in cash from late December through to January expiration. Things were looking kind of choppy by late December, but with the gap up on expiration day, we entered our first SPY trade with put strikes at 138/140, and as the rally continued for another couple days, we entered our second SPY trade with put strikes at 141/143. Keep in mind that January is traditionally a bullish month, as new deposits leave pension and other fund managers with cash to deploy and people rebalance their retirement accounts. But on December 27, a selloff began that saw the SPY close down for 8 days in a row, a phenomenon that has only happened a handful of times in recent history, and has previously always led to substantial recovery. SPY shed 10 full points during that 8-day stretch. Normally, the bottom of that selloff would be the perfect opportunity to enter a third position. The major indexes saw positive closes on January 9 and 10, and we were examining prospects for a third position. But of course expiration was only a week away, plus the markets looked like they may be rolling over into a bearish cycle, so we kept the 3rd and 4th possible positions open (i.e. in cash).

This is a perfect example of the reasons why we trade multiple iron condors every month, instead of just one. Several other iron condor newsletters out there also took major losses this month, but there was a key difference between us and them: we were positioned more defensively. Having only 2 out of a possible 4 trades open leaves you 50% in cash and much less exposed than if you’re “all in” with a 1 of 1 approach.

One other thing that went right this month was … the fact that things went so right in preceding months. We’re not being coy: by trading tighter ranges for larger credits than most other sites do, we’re able to take in more credit during winning months and build more of a buffer to offset losing trades. By contrast, strategies that trade wider condors for a smaller credit can wipe out an entire year’s worth of winning months with just one bad trade (at worst, our losers only set us back a couple months). The rejoinder is always: “hey, but our wider range offers greater protection and higher probabilities of success!” And that’s a nice story, but (as we’ll explain in greater detail in a future post), it’s not true: the thing that causes losing iron condors is usually an intense market spike in one direction, and a slightly wider position will almost never be able to accommodate the spike in reality. When the Dow can drop 300+ points in one day, tweaking your trade to be a bit wider isn’t going to save you, and all those lower credits from prior months mean you have less of a credit cushion to fall back on.

So even after this bad month, our average return per trade is still above 9%.

What Went Wrong

But you’re not here to get some positive caveats, you’re here for blood, right? Fair enough: here are the things that we did wrong this month, and what we’re going to do to fix them:
1. We didn’t exit on time. One clever reader actually wrote in to remind us that our trading rules dictate an exit 4-10 days prior to expiration. But it’s not like we forgot or anything; rather, during the normal exit window the selloff was still in full force and markets appeared to be bottoming near the November and August 2007 lows. So we intentionally held off on our exit, since the relevant technical data points all favored a bounce or at least some relief from selling into expiration week. The real kicker wasn’t so much the exit delay, but more the huge distribution day on January 17, where markets gapped higher and then reversed hard.

The fix: on one hand, it was rational to hold off a bit longer than normal to look for a reversal; at the same time, an exit as late as the 14th or 15th would’ve resulted in far more manageable losses. So going forward, we’re going to stick with the trading rules that have served us so well for so long, discretionary trading be damned. That alone should prevent any major losses going forward, since (this is important) the vast majority of the time, trades exited at 4-10 days out will still have $0.20 - $0.40 of time value left, cutting the size of future worst case scenarios by half.

2. We gave the markets too much leeway. That’s kind of vague. How about: we didn’t tighten our risk parameters to accommodate a turning market. There’s no way to predict the future, but when a bull market starts turning over, it makes sense to tighten things up a bit. Although we had no way to predict an intense selloff of this magnitude (no one did), waiting for more favorable risk/reward opportunities would have kept us out of at least one position.

The fix: We’ve tightened our risk parameters, which will keep us out of more unfavorable trades, and help us get out sooner in case of favorable trades that don’t perform well enough. These parameters aren’t a magic wand, but they would have had us exit one trade with a 10% gain and the other trade with only a 40-50% loss, which is actually right in line with our long term performance, and is actually a pretty decent outcome for a 2-3 sigma market event of this intensity. Of course, that requires taking a longer term view, which seems in short supply these days.

One More Thing

This isn’t exactly a fix, since we’ve been doing this all along, but we’re testing out some new metrics for timing and sizing our trades. Specifically, we’re working on exploiting more of the spread between implied volatility and realized (historical) volatility over time. This should help us structure trades with better probabilities of success, without sacrificing any of the credit we receive from trades.

We’d like to say thanks to all of you who have written in with such supportive and thoughtful remarks over the past several days - we’re really privileged to have such a mature and indomitable group of members. Only some traders have the discipline and the strength to weather a market like this one and stick to their strategy. But those that do are the one who are left standing.