I'm a proponent of back-testing a trade through all kinds of market conditions, gaining confidence in your preferred trade's performance. In the absence of the ability to back-test, it's a great idea to trade in small lots, first with simulated trades and then with live ones, making sure that you trade through several types of market environments.

The object of all this testing is to decide whether you'll make adjustments or just take off a badly performing trade, determine if it's possible to manage losses, and calculate whether the aggregate gains made on profitable trades are greater than the aggregate losses incurred on losing trades. Traders who have done this work will not be as likely to panic under adverse market conditions. They've gained the confidence to get back in with a new trade when they take a loss because they know that, over the long run, their trades work.

If back-testing isn't possible and the trader doesn't want to test trading with small-lot trades, they can employ a different method for testing their trades. It is perhaps a bit clunkier and a little less trustworthy, but it costs nothing extra and can be done with most trading platforms or via CBOE's free tools. Traders can run what-if tests. What if the trader sets up a hypothetical test of a standard iron condor near the close on Tuesday, July 22?

Iron Condor with Composite Options and Their Deltas, OptionNet Explorer Chart:

The $112 loss reflects two-way commission costs as well as a built-in $0.18/contract slippage to try to simulate real-world conditions. If I wanted to do some what-if testing, what would I want to test? Price movement is a given, but let's look at the VIX on July 22 to determine whether our hypothetical trader should be testing for possible changes in implied volatilities, too.

Two-Year VIX Chart, Daily, Chart by Think-or-Swim:

The VIX was rising from a 10.28-percent low not seen in more than two years. The VIX had risen to the 12-ish level that had previously marked most lows, so the time could be ripe for it to rebound and bounce up toward its typical highs, at about 21.40 percent, or roll down toward the lows seen in the middle of the last decade.

A rise in the VIX usually occurs when prices roll lower. Implied volatilities on SPX options would be rising when the VIX is, although that's a somewhat simplified view. Calls and puts and options in different expiration periods might be impacted differently, depending on whether market participants thought the decline was likely to be a short-term one or a long-term one. In any case, SEP options, 58 days from expiration on July 22 point, would likely be impacted. What if VIX--and those implied volatilities--kept rising?

The last time the VIX moved from the 12-ish zone to the 21.40-ish zone was from about 1/15-2/4. The SPX close on 1/15 was $1,848.38 and, on 2/4, it was 1,755.20. That represented a price drop of about five percent.

The SPX close on 7/22 was 1,983.53. A five-percent drop would bring the SPX price down to 1,884.35. The trader running a what-if scenario would want to see what would happen if the SPX dropped to 1,884.35. Don't forget that the implied volatilities would rise, too. The composite implied volatilities for September expiration were at 10.67 percent on 7/22, as computed by OptionNet Explorer. On 2/4, when the VIX was at its last 21.40-ish peak, the composite implied volatilities for the first back-month options were at 16.45 percent, so they were 5.78 percent higher than the current implied volatilities. Let's look at what would happen to that hypothetical iron condor trade if 22 days from 7/22--the same number of days as those from 1/15 to 2/4--the SPX had dropped to 1,884.35 and the implied volatilities had risen almost 6 percent.

What-If Scenario for Dropping SPX Prices and Rising Implied Volatilities, Chart by OptionNet Explorer:

Yikes, that curvy profit-and-loss (PnL) line doesn't look pretty. The increased implied volatilities sank the PnL line into negative territory. Although I can set a pull-down menu at 1,884.35, that second pull-down menu disappears when I take a snapshot. However, I can tell you that the loss at that point would be would be about $480, 14 percent of the margin held for the trade. The PnL line would just be turning red at that point, showing where the maximum intended loss had been set.

What if it had been this trader's view that this scenario could have unfolded? What could have been done? I often bought an extra, Armageddon-type put for my iron condors when they were my preferred trade, and I always bought them when implied volatilities were extremely low. An extra put can be a price hedge, but, more importantly, it's a volatility hedge in this case. Long options have positive vegas, meaning that rising implied volatilities act to raise their prices. Of course, if the long option in question is a call, the price action is working to drop the price, but the rise in implied volatilities somewhat ameliorates the loss. I've heard that during the 1987 crash, some calls gained in value due to the combined effect, although I can't verify that anecdote. However, in this case, we're looking at a long put, and both price action and the change in implied volatilities would be beneficial.

In the times when I was trading iron condors, I was trading in a size large enough that I would hedge with an extra SPX long put. Those puts are too costly, however, for such a small trade, as paying for anything but a way-far-out put would wipe away the profit. The trade can, however, be hedged with an SPY put. Beta weighting the trade is one possibility to determine the correct put, if your platform allows you to test using beta weighting. OptionNet Explorer does not yet allow that capability and neither do some other platforms, so this trade was tested using a single SEP SPY 180 put, purchased for $0.59, at the same time as the original trade entry. Buying at the inception of the trade is important. If a trader waited until the implied volatilities had already begun rising, the put would have been more expensive--in terms of the extrinsic value--and not as good a hedge. Of course, the potential profit would be reduced by $59.00 paid for the Armageddon put plus the $2.50 two-way commissions to buy and then sell it.

With the SPY put's PnL displayed on a separate chart--since beta weighting is not available on this platform--we can roll the implied volatilities up and the date forward, as we did with the previous chart for the SPX iron condor.

SEP SPY 180 Put, with Implied Volatilities Rolled Higher and Date Rolled Forward, Shown on OptionNet Explorer Chart:

Again, the extra pull-down menu is not visible on a snapshot. However, with the SPY at about 188.44--the level roughly analogous to SPX 1884.35--the profit on that SEP 180 put would be about $176. That means that the $480 loss shown in the unhedged iron condor position would be reduced by $176, and so would be a $304 loss. That would still be a significant percentage loss, but it wouldn't yet have hit the maximum intended loss as set before the trade was entered. What I felt that the Armageddon puts did for me in such cases was to slow down the loss and give me more leeway to adjust.

This article has run long already, but the trader running such what-if scenarios could decide to test different hedges or could test adjustments made when losses reached levels somewhat less than the levels reached under the conditions shown above. In other words, barring a flash-crash type scenario, the trader would have been able to adjust on the way down, not waiting until a five-percent drop in the SPX.

Similar tests could be run for conditions under which the SPX reached for upside goals, too, although with the VIX where it was at this hypothetical trade entry, I wouldn't suggest rolling the implied volatilities any lower for an upside test. Normally, when testing an upside move, implied volatilities are run down in such what-if tests, but the implied volatilities are already near their typical lows. Our would-be trader probably can't assume that they'll go lower, although that possibility remains.

We don't always have all the capabilities we would like to have with our chosen online brokerage or charting system. However, we can--and should--find other ways to test our trades and adjust our plans. The method described in this article is the way I tested for at least 7-9 years. Happy testing.

Linda Piazza