Over the last three week, I've heard or read a couple of conclusions about iron condors being voiced rather emphatically. The trouble was that I wasn't so sure those conclusions were true. In one case, I was frankly puzzled by what I was reading.
In that case, a knowledgeable options blogger presented the case against iron condors. He said that, contrary to popular theory about the probability of success of the iron condor trade, an iron condor trader was likely to lose more than invested in the iron condor over a several-year period.
I'm no statistician, but I'll tell you the basic assumptions about the iron condor as many of us trade it. That's going to require me to talk about deltas. When I talk about the deltas in this article, I'm talking about the absolute value of the deltas. Because the deltas of calls are positive and those of puts, negative, some subscribers can get confused when the talk turns to a higher delta than -9.00 on the puts you choose to sell. Sticking to absolute values does away with that confusion.
When I enter iron condors, I tend to sell the first call with a delta below 10, and the first put with a delta (again, absolute value) below 9. I buy my longs 10 points away. Theoretically, we can use the deltas to estimate how likely those sold or short strikes are to be in the money at expiration. Adding them up in an easy, rough-and-ready calculation (just under 10 and just under 9), the likelihood of the underlying ending up outside the iron condor's expiration breakeven at expiration is under 19 percent. That number is subtracted from 100 percent. Therefore, that iron condor theoretically has a just-over-81 percent of profitability at expiration. I spent a long time in a prior article explaining that expiration probabilities are different than the probability that the sold call or put's strike would be temporarily exceeded sometime during the trade, but we'll return to that later.
This blogger's contention was that potential iron condor traders were being led down the garden path. My previous research had shown me, however, that iron condors were indeed profitable over the minimal number of trades to be statistically valuable. This blogger also presented evidence of a statistically significant number of trades, which in my experience must be over 30 trades.
One of us was wrong. So, what did I do? I tested another set of data. On my back testing program, I set up SPX iron condor trades from March, 2008 to April, 2011. I input commissions of $1.25 per contract, a low but obtainable commission price at many brokerages. Because it's unlikely that a trader would be able to get prices exactly at the mark, I input $0.15 less credit for the iron condor than was available at the mark or mid-price. Many times, I'm able to get a balanced iron condor at the mark or close to it if I'm putting the condor on as a single, balanced trade. However, to be conservative, I wanted to introduce some slippage. I also moved up the put a strike if I couldn't get at least $0.50 per contract for the put spreads.
I didn't make any adjustments. This wasn't a test of my trading acumen. This was strictly a test of the probabilities of the iron condor ending up profitable over that length of time. I did close out the trade the afternoon that trading stopped in the SPX options, prior to the next morning's settlement value. I did this for several reasons. I wanted to pay the commissions to close the trade, adding them to the cost of the trade. I also didn't want to deal with the freaky settlement values of the SPX, which I think add a different cast to the outcome. Those freaky settlement values, sometimes far off the previous day's close or even any value traded on the settlement day, are not a true test of where the underlying will trade while the iron condor is open.
What were the results over those 38 trades? The maximum margin or buying-power effect for any one month for these trades was $23,050.00. The realized profit over the 38 trades (38 months) was $31,462.51 or 136.50 percent of the maximum margin ever withheld in a trade. That averages $827.96 per month on the trade.
Granted, this no-touch method is not going to produce a big per-month earnings. Yet, it was producing a gain. The blogger had stated that, if commissions were added, the constant iron condor trader would lose money even if commissions weren't added into the trade. That just didn't seem right to me, and my research again didn't agree with his. He was testing a different trading vehicle, one with a higher beta than the SPX, but that higher volatility would be reflected in the deltas of the strikes he sold. He was entering the trade further away from expiration than the 30 days before expiration that I set up on my test, but again, deltas would have reflected the differences. I had also tested this same premise about a year ago, using a much longer period before expiration as my starting point, and I had found that one profitable, too.
The blogger was right about the heavy toll the commissions take on this commission-intensive trade. While the realized profit was $31,462.51, the broker wasn't too unhappy with the $9,500 in commissions.
What's the point? As I've noted, the blogger had tested a different underlying than the SPX. Perhaps that higher-beta vehicle performed worse. Yet the blogger's conclusion had been that iron condors weren't profitable trades over the long run, and now we know their profitability may be dependent on the underlying chosen. The point is to test these ideas for yourself rather than taking what someone else says on faith. If you do your own testing, you would have come up with many reasons not to trade iron condors with a strict no-touch approach, but that wouldn't have been because it wasn't possible to be profitable over a statistically significant number of months.
I can't move forward without mentioning the primary reason that a trader wouldn't necessarily want to employ a no-touch approach. Losses, when incurred, were often quite large: for example, $17,025 in October, 2008, and then $11,125 the very next month. A $5,800 loss in March, 2010 was followed by a $21,849.99 loss in May, 2010. February, 2011 saw another loss, $3,375.00. Nothing about the probabilities promises that a trader would build up eight or nine months of profits before the first loss was incurred, and then gather another eight or so months of handsome profits before another loss. A trader might start such a program only to endure four months of losing trades in a row, with no profits to cushion the big losses, and then see 32 months of profit . . . if there was any money left in the account to trade after four straight months of losses.
The next assertion I heard was from a trader who was planning a modification of the iron condor which would severely limit the profit available in the middle third of the expiration profit-loss chart but make more profit available in the outside thirds. The trader planned to stay in the trade until expiration. "After all, this trader asserted, how often does price stay in the middle? Not very often." Oh, yeah? I thought. I wanted to find out for myself.
Out of the 38 months I tested, 12 months or 31.6 percent of the time, the SPX ended up in the middle third of the expiration profit-loss graph. That's not "very often," I suppose, but the trader had spoken that phrase with a dismissiveness that had made it seem synonymous with "almost never," and this wasn't almost never. Part of this trader's plan was to immediately exit at a hefty loss if the expiration breakeven was exceeded at any time during the trade, but that didn't happen often, the trader asserted. Hmm. No, not very often, my research agreed, but it did happen five times out of the 38 months I tested. The way he planned to structure the trade, the loss would be somewhat less than in a traditional iron condor if the exit was needed during the middle of the month, but it was still a large loss. Moreover, because the possible profit in the middle of the graph was so small, I worried that the 12 months when that much smaller profit was available would severely limit the profits available to cushion the losses those five months.
I'm not dismissive of either researcher's work. Some valid points were made. However, a lot of people jump into trades because of something said by another experienced trader without any further verification. Before you jump into the new next-best holy-grail trade, do your own testing. If you have the ability to back test, be sure to test a period that includes several different market environments. I've been hearing a lot of traders tout their success in their preferred trades over the last six months, but we've been in a rising-market environment the last six months. Their trades might not be so successful if they had included the months when the markets started tipping over into the sharp decline that would eventually lead into March, 2009. Even if you don't have the ability to back test, you can paper trade a new trade idea for a few months before putting it to the test with live trading. While you're following a paper trade, roll the volatilities up sharply now and then and look at what would happen if your underlying rolled down sharply. You're bright, too, or you wouldn't be intrigued by options. Do yourself a favor and question everything you hear.