The Best Time to Trade Iron Condors, Part 2: Ignore the Trend
...continued from Part One
As we look ahead to 2008, it seems increasingly likely that the U.S. economy is going to fall into recession. As a result, many of our readers are asking whether the iron condor strategy is appropriate for a bear market.
Common Misconceptions About Iron Condors
One of the most common assumptions people make about iron condors is that itís better to trade them in low volatility, non-trending environments. This is an understandable assumption. Unfortunately, itís also totally false. The best time to trade iron condors is in high volatility environments, regardless of the trend.
We discussed the first half of that thesis in Part 1, where we explained why high volatility environments are actually a good thing for theta-positive options trades like iron condors.
In this article, weíll tackle the second part of our thesis. Our claim is that iron condors fare no better or worse in strongly trending markets than they do in flat ones. If anything, our view is that the persistent fear and pessimism sustained during bear markets makes option selling a more attractive strategy.
The tendency of markets to move up and down over the course of any given expiration cycle, even in the midst of a strongly trending secular environment, means that market-neutral strategies can be just as successful as in tranquil economic times.
In short, as long as positions are constructed with current volatility levels in mind, profiting from theta (time decay) is just as viable during a bear market as it is during a bull or non-trending market.
The Trend Is Your Enemy
Weíve all heard the adage ìthe trend is your friendî a thousand times. When youíre riding a popular stock that has strong momentum, such advice seems obvious. But when you have an open iron condor position - or any other options position with positive theta - in a certain sense the trend is your enemy.
Instead, your preference should be for the underlying to calm down and move very little through to expiration. According to our thesis, the ideal scenario for an iron condor is a volatile market (your entry point), which subsequently calms down into expiration (your exit point).
It then follows that the worst-case scenario would be a relatively stable market (at entry) which then moves strongly in one direction, threatening one of the short strikes in your position.
If a sharply-trending underlying in the middle of an expiration cycle is bad news for iron condors, then a market that is generally trending should amount to even worse news.
Dealing With Long-Term Trends
S&P 500 Trend Chart
CLICK HERE FOR THE FULL-SIZED CHART
However, that simply is not the case. While short-term trends can be dangerous for iron condors, a long-term trend that plays out over several months or even years (as illustrated above) is no more difficult to deal with than any other type of environment.
One of the reasons this is true is that the lifespan of a typical iron condor is usually 4-5 weeks. Even in the midst of a strong bear market, where indexes consistently drop several percentage points every month, this trade will only participate in a portion of that movement. By always trading front-month positions, we reduce our exposure to long-term movement. This provides us with the freedom to avoid making directional predictions.
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