In last quarter’s review, I mentioned two things: that we were adding a dynamic delta hedging component to the official newsletter strategy, and that after the newsletter’s underperformance in Q3, the long-term historical record for the strategy suggested that it was actually an optimal time to increase exposure. Happily, that expectation turned out to be true, and the delta hedging component had a very positive effect on performance. The strategy returned 5.67% in the last quarter of the year (and, I should mention, another 5% in the January expiration cycle). With the addition of delta hedging to our strategy, we are executing something much closer to a volatility arbitrage approach, further distinguishing us from the scores of generic iron condor advisories. If you aren’t already a member, we are currently accepting new subscribers. Let me explain how dynamic hedging improves our existing strategy.
Options-based strategies can be difficult to conceptualize, and instead of thinking exclusively in terms of volatility and greek exposures, I think it’s helpful sometimes to borrow from the world of delta one products: specifically, many options strategies can be thought of as variations on the core themes of momentum and mean reversion. A trader who sells a one-month straddle or strangle is hoping that the underlying asset will be less volatile than is currently implied; another way to express the same notion is to say that the trader is hoping the asset will exhibit increased mean reversion over the life of the trade. Conversely, a straddle buyer will only be profitable if the underlying exhibits enough momentum to take it above or below the break-even points of the trade. Outright call and put buyers need to see momentum, too, albeit in their preferred direction.
I mention this because it forces us to think about the kinds of risks we’re actually taking, and whether those are the same risks that we’ve been planning for. An unreflective trader who puts on iron condors every month may not realize that she is expressing a view not just about volatility but also about mean reversion. If the underlying unrelentingly drifts in one direction (that is, exhibits momentum), it is possible for volatility to decline and for a condor trader or other option seller to still end up with negative returns: the implicit bet on mean reversion didn’t pan out. In practical terms, the underlying will be above or below the break-even points of the condor, strangle, or whatever.
Hedging delta exposure dynamically allows us to reduce or even remove that implicit and, perhaps, unintended bet on mean reversion. As delta exposure accrues to the option position, by putting on offsetting trades using the underlying or synthetic long/short positions using options, we can protect ourselves from directional risk without altering the core options portfolio. One downside to a dynamic hedging component is that it requires a little extra work: the “set it and forget it,” facile conception of trading is impossible to maintain. But that understanding was always a dangerous illusion, anyway.
I don’t boast constantly about our past returns or take the hard-sell approach that so many in this industry seem to adore. But I will say that I don’t know of any competitor that offers the level of attentive risk management, continuous product development, and transparency in reporting that we do. If you think we might be a good fit, give us a try.
In the final quarter of 2010, hedging deltas as time passed allowed us to turn potentially losing months into profitable ones, to stay in trades longer than we otherwise would have been able to, and to keep a smoother daily profit/loss profile. October would have seen a basically flat return and December would have seen heavy losses if not for our aggressive risk management. I was initially hesitant to present a relatively advanced strategy to our members, but I have been impressed by the response and by the ease with which our members have learned the technique.
Performance data for the Condor Options newsletter is below, followed by monthly returns and a VAMI (value-added monthly index) comparison. Our benchmark, the CBOE Volatility Arbitrage Index (VTY), tracks the performance of a hypothetical volatility arbitrage trading strategy designed to capitalize on the difference between S&P 500 Index (SPX) option implied volatility and the historical volatility of the S&P 500 Index. All monthly returns measure expiration cycles rather than calendar months.