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Wednesday, April 27, 2016

The life of the simpler Iron Condor trader

As traders, we must constantly question our approach, never rest in our laurels. A perfect way to trade doesn't exist, and rewards in the markets don't come without risks. But, if there is just one little extra edge we can take advantage of, no matter how small, it is our homework to try to find it, prove it and finally exploit it. Nobody gives you anything in the markets, in fact, the market has funny ways to take away from you almost every time you make just a little mistake.

It is with this spirit that I find myself looking at past trading periods several times. For instance, I have probably studied my 2013, 2014 and 2015 trading activity about a dozen times by now. Boring, I know. Tell my girlfriend.

There is this one thing that is always a little annoying: seeing that a position that you adjusted (therefore taking a loss), would have been a winner if you hadn't touched it at all. Which leads to the never-ending debate of whether you should defend positions or just let probabilities entirely play out.

For advocates of taking small losses and defending, the funny part is that when you roll your troubled position out to safer strikes, you want for the market to reverse so that it doesn't hit you for a second time. But then when it finally reverses you say "oh, gosh, I shouldn't have adjusted anything". It's as if you want the market to still go a little against you without getting to hurt you for a second time. Sort of to be able to tell yourself: "well, I did the right thing because I would have had a full loser if I hadn't defended", without having to think about the "gosh, I shouldn't have taken that manageable loss, I shouldn't have adjusted anything". All this has led me to think about the life of a simpler Iron Condor trader: a guy who doesn't want to be over-managing his positions and prefers to let it all play out as Allah wishes. This guy doesn't want to adjust anything, he trusts he will be better off in the end. This is his system:

- Sell an Iron Condor 19 weeks out (133 days). If the options are not available yet, then wait until the first day they become available, which may be 126 days, 125, 120, etc.

- Don't use unbalanced Iron Condors. That is just too complicated maths and he is a simple soul, enemy of anything that sounds just a bit complex.

- Choose ten delta options on each side.

- Do not adjust positions. Just let it all be.

- With a $40,000 account, he will play Iron Condors strictly on SPX and will use 25 point wide wings. He will play 3 contracts per each leg. That is, a 3/3/3/3 Iron Condor every time he plays. This way he will be investing 15% to 20% of his capital in one position.

- He plays only once a month. So, in January he initiates a May position, in February he plays a June position, and so on. Once May arrives, the position in that month reaches expiration, freeing margin (be it a loser or a winner) and deploys a brand new position 4 months out.

- Always 4 positions on, and therefore from 60% to 80%  invested.

Here is how his positions would have turned out in 2014: 

Look at that, not a single losing trade. A +30% year without putting too much effort. Certainly less than the amount of work I did.

A few notes before we continue:
1. The back-test uses end of day prices only, not intra-day, and assumes exactly the mid price between Bid and Ask. We can expect a little worse than that in real trading.
2. We are not taking commissions into consideration, another reason to take that return with a grain of salt.

All that aside, still, a 30% growth is solid, or let's say 25% to account for some slippage and commissions. Still a solid number. So, why not trade like this?

Well, outsized returns come with outsized risks. With this approach in particular, a single losing position would have taken you down by 15% or more. Only one losing position and your +25% year suddenly becomes a more earthly +10% year. Two losing positions throughout the year, and you would have said good-bye to any hope for positive returns altogether. That year just happened to be a one where this particular approach suffered no losses. I tried to back-test 2008, but when you go so far back in time with ThinkOrSwim's thinkBack tool, options just stop showing their delta. Yet another reason (as if there weren't enough) to implement a custom, independent back-tester.

Now, if you suffer two losses not just "throughout the year", but two losses in sequence, one right after the other, then you are in a 30%+ draw-down...just like that. But what are the odds? What are the odds that we will suffer two consecutive losses?

Simple math. We are selling 10 delta options on both sides, so our Iron Condors have around around 80% probability of expiring successfully and 20% probability of getting hurt. The probability of two consecutive losses is 20% * 20% = 0.20 * 0.20 = 0.04 or 4%. This means that 4 our of a 100 times, we will have two consecutive losers, or what is the same, 1 in 25. Because we trade once per month, we can say, that we are likely to suffer two consecutive losses once every 25 months. Because fear is generally exaggerated and options consequently overpriced (otherwise no edge would exist), we could say, it is a little more than 25 months. Maybe 28, maybe 30 who knows. But the point is, two consecutive losing trades will exist, in about two and a half years, and they will take your account down by more than 30%.

A 30%+ draw-down is way beyond my pain tolerance of around 10% max account draw-down. So, in order to account for this, we will now use the same system, but reducing position size to a third, so that when we face the two consecutive losses scenario, our portfolio is not down 30% but a more psychologically manageable 10%. Here are the results:

This is now a more realistic annual return after accommodating the system to my pain tolerance. A little less than what I has achieved on average with my "adjust & cut losses approach", but right there in the neighborhood.

Of course, one year is a small sample size. But the fact is that by not actively cutting your losers, yes you will suffer fewer of them, but when the time comes, each losing instance will cause a larger loss. This leads to a profit curve that is straight up while you are winning, but presents deeper troughs when the bad times come. Something like the following:

As opposed to this, with more frequent but smaller losers:
I prefer the smoothness of the second case. It's up to you to pick your poison in the end, but don't be fooled by small sample size tests that show you the glory. Always try to look beyond the implications of each approach.

By tuning down position sizes you can pretty much adjust any system to your own pain tolerance, just as I did here. Certainly, the laziness of the no adjustment proposal has its allure. Still, two losing positions throughout a year and "hasta la vista" positive returns. Also, in order to keep draw-downs at reasonable levels we have to reduce position sizes, resulting in smaller annual returns than the original impressive scenario.

As for proving which is the superior approach (risk-adjusted returns), the possibilities to test are endless, between defending or not, between rolling the tested vs the untested size, or both; increasing the number of contracts or not when adjusting and by what magnitude; width of the strike prices; balanced or unbalanced Condor, how unbalanced, too much or just a little; going farther out in time and how far; hedge via long options? if so, which ones? Inclusion of the impact of all sorts of commission schemes; entering or exiting not only based on days to expiration but also other conditions, like an oscillator, or general sentiment as measured by extremes in the American Association of Individual Investors survey (AAII) or the National Association of Investment Managers (NAIIM), or really, any other. Only a solid back-testing solution will help provide that part of the answer.


Note: Work on the custom back-testing solution has slowed down recently due to recent time constraints. I still expect to have it ready at some point this year, at least with some basic features. It will initially be available inside and at no additional cost. This is for End of Day SPX and RUT data. Other instruments, as well as intra-day data will not be available (unless we figure out some way to afford the data that makes sense without committing financial suicide).

Related Articles:
The Torture
Frustration (Mentally dealing with extended draw-downs)
Trading Innocence (The things that hurt new traders)

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