Condor Options

Today’s losing trade can be tomorrow’s saving grace.

The graph below plots the risk profile for the trades we currently have open in our iron condor newsletter.  The curved white line represents profit/loss today at various SPY price levels; the other lines move forward in time, with the final line plotting p/l at expiration.  This graph doesn’t model changes in implied volatility, although since we are short vega, profits will rise inversely to implied volatility.

We’re not shy about posting losing results; as evident above, there’s only about a 20% chance that these trades will be profitable in aggregate near expiration (that’s the space between the two vertical dotted lines).  But the news isn’t actually so bad: as long as the S&P 500 is between 690 and 880 near April expiration, net losses on these iron condors will be very slight.  That’s an important result, because months like this one should actually be brutal for market neutral traders: after all, the S&P 500 moved up more than 20% in a span of just 14 days!

One of our positions was entered near the short-term market low.  As the market rose, there were really only a few things that could be done: a) close out the losing trade, b) roll the position up in price or out in time, c) open a new offsetting position, or d) nothing.  The first two possibilities aren’t inferior per se, but they do conflict with the purpose of the strategy, which is to sell option premium at a given higher implied volatility and buy it back later after a period of lower volatility has been realized.  Locking in quick losses and/or “rolling” spreads are techniques that have their own advantages and disadvantages, but our style favors opening new positions when the market has changed significantly – which can mean a substantial price move, a major change in implied volatility, or both.  Doing nothing is sometimes the best approach, but in this case we wanted to reduce the delta (or directional) exposure as the market moved against us.

So we opened new trades as the market moved ever higher, such that we now have lower directional risk and a very wide “tolerance zone” for the duration of the April cycle.

If there’s one reason we publish the newsletter, it’s in order to teach a careful and creative approach to risk management.  We don’t post about newsletter trades and performance all that often on this blog, in part because we’re weary of all the gurus and heavily marketed newsletters out there that tout their winners, ignore their losers, and have nothing to say at all about risk management.  Any creature with opposable thumbs can pick a trade, and options are priced efficiently such that no one trade has an inherent advantage over any other.  What really matters is risk management; if you can survive adverse market conditions and minimize your losses, the winners, as they say, will take care of themselves.

Chart and data: thinkorswim. Photo via Flickr user Marc Torres.