A reader asked us recently about our preference for closing out option spreads prior to expiration. To review, we usually close out any positions that are short gamma at least a few days – and often up to a week – before they expire, since the exponential increase in gamma near expiration makes those positions more difficult to manage. The question was about the how the performance of our strategy would have been affected had we held all positions to expiration, instead of closing them early.
We took a preliminary look at this. Over the last 24 months, holding all iron condor newsletter trades through expiration improved absolute returns modestly, but increased the standard deviation of returns significantly; net risk-adjusted returns (Sharpe ratio) were worse. That’s more or less as you might expect: holding trades for longer allows you to collect more premium on each individual trade, but also increases the chances of a winning, breakeven, or slightly losing trade becoming a major loss. The old saying is that premium sellers eat like birds but, ah, defecate like elephants, and that’s largely true; in that context, waste management and risk management are the same thing, and deserve a lot of emphasis.
Given how infrequently this strategy trades, 24 months isn’t much data to go on; one trade switching from a nice win to a big loss has a major impact. We may run a more thorough backtest at some point in the future, although one would expect more or less the same intuitive results – improved absolute returns at the cost of much higher risk. Practically speaking, most traders will have better long term success with strategies that have superior risk-adjusted returns, rather than absolute returns, for the simple reason that it’s much less tempting to abandon or alter the former. It is easy to be a “mechanical” trader when you’re running tests on historical data – dead data can’t impact your live account. It is much harder to stick with some strategy in the midst of its largest drawdown to date, and for most traders, giving up a smidgen of raw performance in exchange for less psychological stress is a good bargain.