RUT iron condor - an insurance model?

[thanitp 1]

Hello all,

 

I am wondering if trading ONLY iron condors on a broad index like RUT or SPX is a viable trading strategy for someone who doesn't have much time to follow the market? Let me first explain that when I say "not much time", I am aware that we still need to adjust from time to time, not really a set-and-forget type of trades.

 

The kind of trades I'm talking about is what many people call it "the insurance model", where you aim to be exposed to an iron condor of an index every month or so. Statistical edge would make you come ahead in a long run. Adjustments would be required from time to time. This is a bit different from RUT trades we had here because Kim would actively search for a specific point to enter instead of being on a trade all the time.

 

This strategy is highlighted in details in a few books. One that I read carefully is "No-Hype options trading" by Kerry Given. I know it may not be that straightforward as he wrote, but the only complexity I see is in the adjustment methods - this is the only place where I see a decent amount of works need to be done (learning to find methods that suit me the most).

 

The reason I ask this is because I can see that I may not have much time to follow all earning trades in the SO portfolio in the near future. I feel that this strategy (earning) in general works awesome and I am so far very happy to be in this community. However, some did require me sitting in front of the computer within minutes after notifications. This may not work out for me in the future due to personal reasons.

 

So, I know there's no such holy grail, or tons of people would've been rich long before my time, but still the mindset of the "insurance model" iron condor just feels like it can't lose in the long run. It does look like an insurance company, in which making money is boring, but a sure thing. If the only problem is that you can't get rich quickly with this (in a relative term, compared to earning trades, not those hypes claiming being a millionaire in a week), I will start studying this even more seriously.

 

Thanks for any input.

[Kim 7,475]

This is a great question.

 

So first let me say that I'm a big fan of irons condors. However, there are few issues with trading iron condors only.

 

First, the time required depends on the deltas you trade. If you trade relatively high deltas (20-25), you will need to adjust fairly frequently. The lower the deltas, the less adjustments needed, and the probability of success is higher, but the potential reward is lower as well.

 

However, here is the biggest problem: in the long term, the strategy will probably make money, assuming right risk management. But despite all good intentions, from time time you will experience losses, and the size of the losses might be fairly big. So the question is how much of your capital are you ready to allocate to ICs? You can spread the capital between few indexes/ETFs. like RUT, SPX etc. but they are highly correlated, so any big move in the market will probably cause all of them to lose money. Depending on the size of the move, your management skills and the deltas of the sold options, the loss can vary between 20%-50%. So in my opinion, It would not be prudent to allocate more than 25-30% of your account to ICs. Assuming overly optimistic scenario that you are able to make 7-10% per trade, that's 2-3% return on the overall portfolio. When you experience a loss, the account will lose 7-15%. Assuming 2 losses per year (again, very optimistic), the overall return might be in the 10-15% range - again, assuming good risk management and not too many market moves. Personally, I'm not this is worth the risk.

 

If you check out some of the services that trade exclusively ICs, this is what happens to most of them. They produce 5-10% many months in a row, but 1-2 times per year, they have 30-50% loss. Even if you allocate 50% to ICs, overall return will be not that impressive, and the drawdowns will be fairly large.

 

Which brings us to the next question: would you trade them month after month, even when IV is in the low end of the range and the credits are really not attractive, like now?

 

This is why I advocate ICs only as part of diversified portfolio and not as exclusive trading.

[cwelsh 1,497]

Kim did a great job on this post, but I want to add a few things.

 

When I first started with options, I traded ICs only -- primarily on indexes (SPY, RUT, etc.).  I experimented with various deltas, finally settling on a formula I liked.  I expanded it to include equities as well, and learned that the best instruments for ICs and RICs were either indexes or highly volatile stocks -- things like IBM and other low beta large caps, you would just get torched on.  Never enough credit to cover the real risk (if you could get 3% a month, that was stellar), but then you'd have once or twice a year, a large move, and lose 75%.  Taking the other side of the trade was death by a thousand cuts -- 3-5% every single month, just waiting for that move.

 

Eventually though I built a model that could routinely return about 10-12% a year on each trade (so my RUT trade would return 10% on the year).

 

The only problem is, as Kim alluded too, is position sizing.  Let's say I have a portfolio of $100K, and I decide to allocate 10% each month to a RUT IC trade.  I make 6% 10 months, lose 20% one month, and lose 30% another.  Well that's a net 10% return, IF I trade $10k each month.

 

BUT, if this is my only trade, then my returns look like this:

 

$100K, $106K, $112.3, 119.1.....then I lose 30%, down to $83K, four more months of 6%, back to $105K, then I lose 20%, down to $79K.

 

If you ever have two or three months of losses in a row, you're in a position where it could take several years to get back. 

 

So you CANNOT UNDER ANY CIRCUMSTANCES commit 100% of your portfolio to index condor trades.  Particularly as when one trade gets blown out, multiple tend too (e.g. if your RUT condor is a loser, in all likelihood your SPY will be as well).

 

You must must must must position size, and have a set monthly allocation.  Otherwise you're just screwed over time.

 

Again, this can work, and I've made it work, but I cannot advocate trading just these.  It can be a good portion of a diversified strategy though -- such as having a 55/40 long/short portfolio, and allocating 7.5% to a RUT and SPY IC each month.  If there's a big move up and your ICs are blown out, your longs do well, a big move to the downside and your shorts do well, otherwise you earn income from the ICs.

 

Of course that assumes you're good at pairs trading .

[thanitp 1]

Thanks both of you very much for insightful replies. I knew a huge loss can come but never had a feel of how much approximately that would be. Also, your caution on position sizing is great - never thought of it that way before.

[cwelsh 1,497]

I'm actually in three ICs now (well two RICs and one IC), but they only are taking up 7.5% of my portfolio (each a 2.5% trade, which represents a 1/4 trading block).  So there's definitely a place, just manage appropriately. 

[fradav 1]

I'm currently going through the sorry situation you refer to above, sold a RUT iron condor last week using a large portion of my margin. There was a small spike in volatility on day I sold it (RUT dropped to 924) so I thought I could get benefit on declining volatility.

 

Within a week the RUT is up 46 points, and close to my short call (980, long is at 1010). I closed the put side for profit but my paper loss is still large.

 

Only positive is that it's June so still 43 days to expiry.

 

Am considering rolling out to July 980/1010 (for a credit) while I still have decent credit for my 1010 call, and opening another put spread.

 

Of course I'd be there for another month waiting for a retraction that might not come. But at moment my goal is simply capital preservation.

 

But I've learned a serious lesson regarding position sizing. And (sgain) that I don't enjoy the trade (IC), the psychology of fearing both a rise and a fall completely negates the perception of it's 'safety' (I placed delta 10-13s)

 

Any advice much appreciated!

Edited May 8, 2013 by fradav

[cwelsh 1,497]

First, I never trust the safety of the stated deltas as calculated -- they almost ALWAYS understate volatility and market risk.  I have built an entirely different risk model based around standard deviation moves. 

 

If I was looking to trade the June RUT IC, I would calculate a 1SD, 2SD, and 3SD move over the last 14, 30, 60, 120, and 365 days, then weight each (heaviest weights to the 14 and 30 day periods).  Let's say a weighted 2SD move was 40 points and a 3SD move 60.  I would then go look at the June prices, OVER 60 points out, and see if I could get at least a 5% return.  if not, then I go to OVER 40 points out and see if I can get a 10% return.  If neither qualifies, I don't trade it.  You of course have to come up with your profit/loss margin.

 

The other lesson Ive learned is don't out think the market -- that's why I like non-directional trading.  You right now are wrong on your trade.  Don't HOPE it will get better, it's just as likely to get worse.  What if the market keeps going up for another 2-3 weeks?  You're really screwed then.

 

Which leaves you with two options:

 

a) close the trade, take your losses and move on;

  roll the trade to another time period forward -- BUT realize this is really closing the first trade, taking a loss, and then opening an entirely new trade.

 

It took me several years to realize the second point.  The money you had, and hoped to make, is gone.  Before doing ANYTHING, make sure what you do is the best trade you can make.  Let's say you're down 20% right now, you can take that loss, and invest your remaining 80% in trades that stand a good chance of working.  OR  you can "let it ride" on a trade that might lose you more, that at the end of the day, even if they work, might not pay off as much as a different trade.  This trading psychology is, in my opinion, the single most difficult thing to master in trading.  You don't want to let go of initial capital, or take losses, if the trade might revert.  This is a dumb way of thinking.  The opposite is just as dumb, I can't count how many times I've said "well that trade is already up 25%, I'll let it ride for another day and even if it goes down 10%, well I'm still up 15%."  That's just stupid.  If that happened, then I have a 10% loss. 

 

I have changed, mostly, to the right way to think.  Now I look at possible trades every day.  Last week, I even closed a calendar at a a loss (that I didn't think would be profitable for an entire week) so I could have capital to enter into a higher probability trade. 

 

So, that rant aside, what I would do is:

 

1.  CLOSE THE TRADE (and in the future have set points to close ICs at, I typically try to close at a 25% loss on the trade, though that slides around depending on how close to expiration I am -- I'll carry a higher loss percentage if the trade is not yet in the money and I'm one day from expiration).

 

2.  THEN look at the trade you're thinking of rolling too -- if it looks like a good trade, then do it, with appropriate position sizing.  If there are better trades, do the better trades.  If you can't find any good trades, sit and wait.  As of today, Im about 85% in cash in my option account.  Two weeks ago I was on a severe tilt, having used up 90% of my available margin (so trading well above the total cash in my personal account).  Take the trades that come to you -- even if you don't see any good ones for a week.  And if ONE good trade comes along, don't over position size.

 

When position sizing IC's, position size based off of margin requirements.  You might get a $1.00 credit on a $10.00 spread, so have $900 of margin requirement.  Don't forget that is a $10 investment -- NOT a $1.00. 

 

And, don't be "afraid" of ICs -- they're one of the easiest ways to make money -- but you are correct, you HAVE to position size properly, and have preset exit points.  And once you have them, stick to your rules.  The ONLY time my trading accounts have suffered was win I violated my position size rules, my risk parameters, or something similar (well that and natural disasters such as hurricanes or tornadoes, had outsize losses due to both of those).

 

Anyways, if the above is not clear (and its been a VERY LONG day) just let me know and I'll try to clarify.

[fradav 1]

Chris, thanks a lot for your great advice, much appreciated.

 

Been reflecting on it and you're right about taking the loss and trying to use the remaining funds to make the best investment possible rather than holding onto a losing trade in the hope of a market retraction, in which case the losses can escalate out of control, in synch with my blood pressure.

 

My brain is inclined to avoid taking the loss, as I feel like I'm buying back OTM calls after a euphoric bull run, but as you say, it's not wise to try and out-guess the market. But I know I should act soon.

 

Thanks again for your help Chris.

Edited May 9, 2013 by fradav

[cwelsh 1,497]

No problem, that's what we're all here for. 

 

In a perfect world, I wish I could re-examine every one of my trades every day and make sure I'm in the best ones, but I don't have time to do that.  So, we all make best with what we can -- but letting losers run is never a good idea.

[Guest giorgio]

Chris,

 

what do you think about Ic for 2 weeks whith a delta beetween 10-12%. the decay time is great and if spx goes up , I close the position and I rolled with the same expiration if it's the first week  but double my position to keep my credit.  Is possible with having enough cash.  

Have you already done that  with IC? Thanks

[Marco 221]

2 weeks and 10% delta? That's the 'picking up dimes in front of a steam roller strategy'. The question is how often does the steam roller get you. 1 out of 10 times is enough to erase all the profits from the 10 trades. And with only 2 weeks to expiry the trade reacts (as in loses money) very quickly if things go wrong - not much time to stop loss or adjust.

I think even in the current low vol environment but with a strong trend that strategy would have cost you quite a bit.

But you are talking to someone who always prefers to be long the 10 delta option, certainly not short. Chris seems to make money selling 10 delta though so over to him

[Kim 7,475]

Check out those guys - http://www.5percentperweek.com/customer/customerMain.php?section=tradePage&step=viewClosedTrades.

 

Scroll down to 2013 performance. They are selling around 10 deltas a week before expiration - similar principle. Note how they have 4-6% gains for few weeks and then a week of 20-50% loss. With the negative gamma so high, it very difficult to impossible to prevent those occasional big losses.

 

With ICs, it is always a race between gamma and theta. The closer you get to expiration, the higher your theta, and if the price doesn't move, you will be okay. But if it does move, the gamma will kill you.