As we look ahead through 2008, it seems increasingly likely that the U.S. economy is going to fall into recession, and many of our readers have been asking whether our strategy is appropriate for a bear market. One of the most common assumptions people make is that it’s better to trade condors in low volatility, non-trending environments. This is an understandable assumption. Unfortunately, it’s also totally false. The best time to trade condors is in high volatility environments, regardless of the trend. We discussed the first half of that thesis in Part 1, where we explained why high volatility environments are actually a good thing for theta-positive options trades like iron condors.
Here, we’ll tackle the second part of our thesis. Our claim is that iron condors fare no better or worse in strongly trending markets than they do in flat ones. If anything, our view is that the persistent fear and pessimism sustained during bear markets makes option selling a more attractive strategy. More importantly, our primary claim is that the tendency of markets to move up and down over the course of any given expiration cycle, even in the midst of a strongly trending secular environment, means that market-neutral strategies can be just as successful as they are in more docile economic situations. In short, as long as positions are constructed with current volatility levels in mind, profiting from theta (time decay) is just as viable a strategy during a bear market as it is during a bull or non-trending market.
Ignore the Trend
We’ve all heard it a thousand times: “the trend is your friend.” When you’re riding a popular stock with lots of momentum, that’s obvious enough. But when you have an open iron condor position – or any other positive theta options position – in a certain sense the trend is your enemy. Instead, your preference is for the underlying to calm right down and move very little through to expiration. So if the ideal scenario for an iron condor is a volatile market (your entry point) which subsequently calms down up to expiration (your exit point), then the worst case scenario would be a relatively stable market (at entry) which then moves strongly in one direction, threatening one of the short strikes of your position.
So the thinking goes that if a suddenly trending underlying in the middle of an expiration cycle is bad news for condors, then a market that is generally trending would amount to even worse news.
But on the contrary, a trend that is playing out over several months or years in an index or other underlying instrument is no more difficult to deal with than any other type of environment, for several reasons:
1. The life of a typical iron condor (at least according to our strategy) is never more than 4-5 weeks long. So even in the midst of a strong bear market, where indexes consistently drop several percentage points every month, our trade will only be participating in a portion of that movement, and then we’ll be out. By always trading front-month positions, we reduce our exposure to longer term movement, and we don’t have to attempt to make directional predictions.
2. Even during a strong trend, indexes and equities never go straight down or straight up. They vacillate and bounce and pause and drift, and it is this tendency, not the presence or absence of a trend, that makes iron condors profitable. It is the passage of time, not the movement of price, that generates returns. At right is a 10 year monthly chart of SPY, the ETF that tracks the S&P 500 index (click to expand it). This chart includes the bear market of 2000 – 2002 and the bull market of 2003 – 2007, assuming that 2008 marks the start of a downturn (which seems likely but isn’t certain). One noteworthy point displayed here is that, from any one month to the next (displayed as red and white candlestick bars), SPY very rarely closed more than 10 points from where it opened. During the bear market that started in 2000, if the bodies of your front month SPY iron condors were 7-10 strikes wide, you would have winning trades most of the time. During the bull market that started in 2003, the bodies of your condors could have shrunk to 5-7 strikes without incurring too many losing trades. These are very general estimates, of course, but the main point remains – that as long as trades are constructed with current volatility levels in mind, market trends need not have a conspicuous impact.
3. Options prices change to reflect different market environments, and we can use that market mechanism of automatically pricing in new information to help us construct positions. Instead of choosing strike prices for our condors based on where we think an underlying is headed, we construct positions in part by paying attention to what the pricing data tells us. Let’s say we construct the following trade, with SPY at $140:
+1 February 130 put
-1 February 132 put
-1 February 148 call
+1 February 150 call
and we find that we’d receive a credit of $1.25 per contract for this position. Unless volatility has spiked recently and we have a strong thesis that volatility will plunge soon and this credit will promptly shrink, a credit that large for a position like this would set off some alarm bells, telling us that the body of our trade isn’t wide enough. (This trade would actually bring in around $0.77 per contract as of 01/11/2008.) So we can use options pricing data to help us adjust to any significant changes in the broader market environment as needed.
Trading With the Trend (When You Have To)
In spite of the caveats and analysis above, there still may be brief periods in which a very strongly trending market threatens the success of your positions, or at least seems likely to do so in the future. Here are some ways to deal with that scenario:
- Add positions to take advantage of market movement. Instead of trying to adjust or fix broken trades, it’s smarter to add new positions that reflect the changed situation, thereby smoothing out the aggregate risk curve of your portfolio.
- Lighten up on your allocations until a clearer picture or less choppy scenario emerges. That way you’ll have more capital do deploy as soon as you’re more confident about things. Asset allocation is always extremely important, and is one of the areas that new traders often misunderstand or underemphasize.
- Use iron condors to hedge existing directional positions. If you’re certain we’re in a bear market and you’ve got some major short positions going, iron condors and other market neutral options strategies can protect those short positions in the event of a temporary reversal or other surprise.
In conclusion, we want to emphasize that the appropriateness of any strategy depends on much, much more than whether or not the equity markets are exhibiting a trend or not, and that there are very few – if any – strategies that can become helpful or unhelpful simply because stocks change direction. Risk management, asset allocation, and discipline are far more important to a successful options trader than knowing where the markets are going tomorrow or next year.
[tags] options, iron condor, expiration, volatility, trend, momentum, markets, risk, trading, indexes [/tags]