Condor Options

Two types of traders really thrived in October – the uber-bearish, and the nimble.  Since our Condor Options newsletter follows a non-directional strategy, we aren’t poised to profit from market swings.  But we do try to be nimble, and subscribers were subjected to a rather unrelenting series of pleas for caution and for a move to cash throughout September and October.

On September 12, we said that we were “trading small” and were “cautious – as we get conflicting high-volume moves back and forth, the likelihood only increases of the market resolving this tug of war decisively in one direction, and you don’t want to be caught flat-footed.” [Most links are to the quoted posts on the secure members area of the site - Ed.]

On September 15, we said that “we could go on all day about the importance of cautious and smart and careful asset allocation.  One or two of you might have gone hog-wild on yesterday’s trade; please don’t do that.  If you do ever discover that you’ve over-allocated a position, don’t feel bad or worry about increasing your commission bill – just resize the thing and feel glad that you’ll be able to sleep soundly at night!”  And the following day, in our Three Survival Techniques post here on the free blog, we mentioned the importance of careful asset allocation, of respecting stop-loss points and exit criteria, and of using leverage only as a tool for reducing risk.

By September 18, we were almost fully in cash and were even disregarding the signals generated by systems that assumed normal prevailing market conditions:

In this climate, we’re actually quite open to the idea that systems that are well-optimized to squeeze extra profits out of normal market fluctuations may be particularly vulnerable (by virtue of being over-optimized and hence too aggressive) to unusual market conditions.

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We don’t have anything new to add to previous comments trading-wise: staying mostly in cash and keeping any positions small is still the order of the day.  Besides a few long-term investments and some small-sized spreads (the newsletter trades plus 10 or so others), we’re keeping our powder dry.  Even though odds of a multi-day short-covering rally seem to be increasing, there’s also the Rumsfeldian category of the “unknown unknowns” that could surprise us at any time with another scandal or failure or collapse.

“Unknown unknowns,” indeed.  In our weekend update on September 21, we said, “we apologize for being so repetitive, but it’s still the best advice out there: keep plenty of cash on hand, keep your positions small, and don’t get emotional.”  Reminders on the 30th (“we still want to emphasize caution and risk management above all else”) and on October 5th (“stay mostly in cash!”) were the last opportunities people had to take decisive action before the worst of the selloff really hit.  The S&P opened at 1097 on October 6th, so even someone who waited until that late date would have dodged the 23% decline that followed.  On one hand, it’s been really gratifying to hear from readers who heeded these warnings and were able to escape the crash; on the other hand, we’d rather have been wrong and not be faced with such morose markets.

The good news is that, as we’ve been advising our subscribers, periods following intense market selloffs historically have been the most profitable ones for our strategy, and as implied volatility has already declined from its earlier peaks, we are already seeing some fantastic profits on our positions for the November cycle.  An elevated volatility environment is torturous for swing traders and ulcer-inducing for stock investors, but it’s actually the ideal environment for option sellers.

Performance Comparison

• S&P 500: (22.46)%
• Dow Jones Industrials: (19.72)%
• Russell 2000: (29.21)%
• S&P 500 Covered Call Fund: (17.70)%
• Condor Options: (100)%
• Note: the period measured is from expiration to expiration, rather than from the start of the month.

The 100% figure above simply refers to the fact that our trades closed at their stop-loss points, rather than to any overall portfolio return.  That’s a huge difference, so let’s be clear on exactly what that means: just as with any ordinary stock trade, options traders are able to decide in advance how much capital they want to risk on a position, and then set their stops accordingly.  In this case, our newsletter trades behaved exactly as you would expect them to during an historic market collapse – they hit their stops and were immune from any further damage.  In other words, even a trader who ignored the relentless warnings we chronicled above and persisted with a full slate of normal-sized trades would have suffered no more damage than he or she had decided in advance was an acceptable amount.

That’s a far cry from the portfolio-busting devastation that so many buy-and-hold investors have experienced this year.  Tragically, it is the “conservative” buy-and-hold crowd who were taking on unacceptable levels of risk without even intending to do so. One of the perennial misperceptions about options is that, because they employ leverage, they are an inherently riskier vehicle.  But nothing could be further from the truth: provided you practice smart capital allocation, options can actually be used to reduce your risk exposure versus a standard stock portfolio.

The chart at right is taken from our updated Performance page, and it displays the performance of a model portfolio tracking all newsletter trades since inception, using 1/4 sized allocations and an “income” orientation – i.e., not compounding returns.  Information regarding our Sigma Stop indicator is available to members, but even without that addition, this relatively cautious portfolio is flat YTD and is up over 50% in less than two years.

October Iron Condors

• SPY 116/118/134/136
• SPY 111/113/131/133

What mattered this month was the news, and nothing but the news.  As both the above positions closed at their stop-loss points, there isn’t much to distinguish them from one another.  There is, however, one important lesson we would add here: the wide-body, low-credit iron condors favored by so many traders are actually higher-risk trades, and provided no added protection during the last expiration cycle.  As iron condors become increasingly popular even among individual retail traders, more and more “guru” sites are cropping up purporting to teach the strategy.  Usually, such sites opt for extremely far out of the money spreads, which bring in a very low initial credit and are supposedly high probability trades.  But there are two key disadvantages to using such far OTM credit spreads: 1) they are inherently higher risk – you’re often risking $9 to make $1 – and 2) they offer only illusory protection, since their “high probability” status relies on the prevailing volatility environment and will quickly disappear in the event of a market selloff like we saw in October.

Presumably, the point of such low-credit, “high probability” positions is to dodge severe market declines.  But the volatility explosion and dramatic selloff we saw last month had the same effect on those wide body condors as it did on our narrower trades.  The difference is that, since we bring in more premium during winning months, the impact of any one or two losing positions is far less severe, whereas the strategy most of our competitors pursue will require much longer to recover.

October Reading

Here are some posts from the past month that are worth checking out if you didn’t catch them the first time around:

• Historical and Implied Volatility Crossovers
• Laissez Faire: A Dialogue in One Scene
• VIX Futures Market Outlook
• Three Theses on Volatility
• The VIX Has No Causal Power