Tue, Feb 17, 2009 | Jared Woodard
The conventional wisdom about iron condors and other market-neutral option positions goes like this: “These strategies are profitable when markets are not trending in one direction. They are unprofitable during strongly trending markets.” Even Investopedia opts for this one-dimensional explanation:
This strategy is mainly used when a trader has a neutral outlook on the movement of the underlying security from which the options are derived.
There are two problems with the conventional wisdom. The first is that it’s false. The second is that it omits the real purpose of market-neutral spreads like iron condors. In this post, we’ll explain why the broad market trend is not the primary concern of an option seller or iron condor trader.
The Trend Is Your Mild Acquaintance
It is necessary to be very clear about the time frames involved here. When most people refer to a trending market, they seem to have in mind a movement spanning several weeks, months, or longer. Contrast that with the life of a typical iron condor position, which is never (for us) much more than 3-6 weeks. A broad market trend lasting several months will inevitably be punctuated by all manner of fits and starts, and it is actually rather common for an underlying at day n of a trend to be at the same price level as it was n minus 30 days ago; obviously, an iron condor held over that span will likely have been profitable, and a trader looking at price action over that period may not even be able to discern the broader trend. To relate the appropriateness of a given strategy to some question of price movement, it’s clearly necessary to have one relevant time frame in mind.
Another problem with the conventional view is that it ignores the effect of a bullish trend on implied volatility. If an asset shifts from a downward or flat regime to an upward one, implied volatility will tend to decline, and that benefits any option position that is short vega – which includes iron condors. While a fierce and sustained rally could push beyond the call strikes of a condor trade, markets tend to melt down, not up.
What about bear markets? Clearly, any iron condors that were already open in late September or early October 2008 would’ve closed at their maximum loss points. But even during the worst of the turmoil, you could have opened an iron condor on, say, October 10th and had a profitable outcome (click image at right to enlarge). Likewise, iron condors were plenty successful during the strongly trending periods of March-May and May-July in 2008. By keeping the time frame of trades reasonably short, it is possible to make mean reversion, rather than momentum, the primary factor determining profitability.
One final point to keep in mind is that strong trends aren’t really a problem for those who are nimble, e.g. for traders who spread capital out across time as well as across price levels. That may require entering multiple iron condors at different times and with different strike prices, trading double diagonals and other time spreads, hedging periodically with the underlying, etc. The specifics aren’t as important as the general idea that it is ultimately one’s greek exposure that matters, not the particular characteristics of a single trade.
Whether or not one should trade market-neutral option spreads is not necessarily a matter of whether the underlying is trending, but rather a question of whether a sufficient amount of price volatility is already reflected in the implied volatility at the time the trade is opened. Iron condors are not about price. They are about volatility, and it is the volatility characteristics that should be emphasized when considering this strategy. We’ll discuss that topic in more detail in a subsequent post.
[For more on how market trends relate to trading option spreads, see our The Best Time to Trade Iron Condors, Part 2: Ignore the Trend.]