One point I emphasize over and over—no doubt to the annoyance of veteran subscribers who’ve heard it hundreds of times before—is how crucial risk-management is to achieving high risk-adjusted returns. Keeping losses small, and locking in profit when you can—not when you have to—are among the keys to profitable trading over the long-term. I harp on the risk-management theme again in this post because the December and January cycles provided a perfect example of how these principles work well for the Calendar Options newsletter (and how we could have applied them better…I’ll get to that later).
Last week we closed our January positions for a Model Portfolio return of 4.38% (not including commission costs). Our goal is to average 3%–5% per month, so that makes January just an average month. Had we kept all of our positions open until Friday afternoon, as it turned out, we could have almost doubled that return; even after selling the Jan/Feb double-diagonal on Tuesday, the iron condor and butterfly hedge together could’ve handed us about a 40% increase in our total return for the month. Note the phrase: “could have.”
What happens in Vegas…
…has no place in an income-oriented options strategy.
Those hypothetical 6–8 percent returns required a gamble—that Friday afternoon the S&P 500 would be within a few points of where it closed on Wednesday. With the market in a strong uptrend, against the backdrop of ongoing event risk both from Europe and from the potentially market-moving U.S. economic data scheduled for release Thursday morning, that would’ve been a big gamble…one that just as easily could have cost us the majority of the unrealized profit we booked Wednesday afternoon.
Neither technical trends nor event risk (except with regard to earnings, when we trade options on individual company stocks) drives our strategy, and had there been two or three weeks left before expiration, those factors would have been of little concern. But in fact, part of our risk-management strategy is that a week before expiration, we reduce some of the gamma that’s built up over the preceding weeks—by closing some, if not all, of our positions. This time, instead of closing positions when we had to (i.e., Friday), we locked in a healthy profit on Wednesday—because under the circumstances, the risk of waiting outweighed the potential reward.
The best laid schemes*
Contrast this with the December cycle. With the benefit of 20/20 hindsight (and an analysis of December and January SPY option pricing), I discovered that I misjudged our risk/reward profile going into expiration week when deciding to keep both of that month’s positions open over the weekend. “Misjudged”: In the context of a strategy like Calendar Options, that one word calls out two mistakes.
The obvious one is flawed judgement: I failed to account for the fact that market behavior deviates significantly from theory around dividends. December SPY options pricing a week before expiration reflected little or nothing of the fourth-quarter dividend to be awarded to shareholders a week later, and the entire value of the dividend was factored in gradually, but at an accelerating rate, over the course of just four days. Moreover, January options pricing remained virtually unaffected by the dividend.
From the viewpoint of a short-term trader, this makes some sense. But most widely available option-analysis software assumes a continuous dividend yield, and therefore fails to accurately predict pricing near ex-dividend dates. The theoretical model makes sense for long-term investors, but in today’s climate, at least, short-term trading dominates options pricing, certainly when it comes to dividends awarded near expiration. It’s embarrassing to admit that I missed this simple fact—but at Condor Options we put subscriber education and continuous improvement ahead of personal pride.
But none of this is really all that important against the backdrop of the other mistake—letting subjective judgement affect trading. Even if the software simulation were accurate, a manageable-looking risk profile is no excuse for breaking the rules on which the strategy is based and proven through rigorous backtesting. Had we (I) followed the “Reduce Gamma Ahead of Expiration Week” rule, we’d be showing a 2% profit for December instead of a 3% loss (and a return for the fourth quarter in excess of 5%).
To end on a more positive and promising note: Having learned from the above mistakes and, in spite of them, having at least followed the rule that worst-case losses should, if at all possible, be contained to no more than we can expect to recover in a good month (or a few average ones), our Model Portfolio is already back to where it was at November expiration. Thanks and kudos to the vast majority of members who didn’t let 2011′s under-performance discourage them from sticking with a proven strategy through a bumpy year, and are now off to a good start towards the possibility (no guarantees, of course) of returning to our historical annualized return of 15% to 20%.
Tags: risk management