VTS Iron Condor Strategy - Broken or Par for the Course?

VTS Community,

We left off yesterday's discussion about negativity bias with me asking 3 follow up questions about the current drawdown we've experienced in the Iron Condor Strategy.

1)  Is the drawdown significant or are we suffering from negativity bias?

2)  Is it the result of the current market environment, or something else?

3)  What can be done to right the ship?

1)  Is the recent drawdown significant?

Every investing strategy will have its own relationship between risk and reward.  To come to any meaningful conclusions about the current state of things, we have to compare results to the strategy's own history.

Our Defensive Rotation Strategy for example, given that it utilizes 2x leverage on the Nasdaq, it can go on very good runs of performance.  Long-term annual return of over 31%, and as I mentioned yesterday it's up over 80% this year.  With high reward comes risk though, and the average of the 3 largest drawdowns in Defensive Rotation is 23.71%.  You can't have huge reward without some extra risk, that comes with the territory.

Our Iron Condor Strategy on the other hand has different goals and a different range of performance statistics.  Updated Jan 2012 - today:

The goal of this strategy is totally different from our ETF strategies like Defensive or Tactical which can be viewed more as absolute return strategies.  The Iron Condor Strategy though is targeting consistent profit with no correlation to the S&P 500.  

We want to have a portion of our portfolio that can perform well when the stock market is just chopping around without any consistent trend.  The Iron Condor Strategy excels at that, with a long term rate of return of 16.73% a year with almost zero correlation to equities.

So are the recent losses significant?  Let's highlight the 3 largest drawdowns in the strategy and answer that question.

Clearly the strategy was cruising along as well as it always has, up until two months ago.  So what happened?  Well, there's two ways to look at this.  On one hand, the current drawdown is significant because it's now the 3rd largest for the strategy since inception 12 years ago.  On the other hand though it's only -9.51% which is barely over half the long term CAGR of 16.73%. 

When put in the proper context, I don't think it's anything to be concerned about, but I do understand why people are asking.  4 out of 5 recent trades have lost money, which is very rare for our high probability Condors to experience.

2)  Is it the result of the current market, or something else?

Remember what an Iron Condor Option is at its core.

It's a market neutral Option spread that can profit if the underlying security goes up or down.  That sounds fantastic, the true holy grail of investing right?  Well, yes and no... 

We can definitely expect a lot of winning trades and consistent results.  However, stop-losses will be breached if the underlying security moves too far in either direction. 

Now as lesson 17 of our Iron Condor course explains, we do use wide wing Iron Condors so the profit range is very generous.  In strong trending markets though, our expanded margin for error still won't be enough.

So why has the last 2 months been a little rocky performance wise?

S&P 500 rolling performance comparison:

As the chart above shows, the last couple months have been very strong for the stock market.  Now we're not complaining of course, we've got 3 other strategies that are crushing it so high fives all around.  When it comes to Iron Condors though, remember historically strong trends are the only enemy.

Trends up or down are not equal

Another thing to keep in mind is that markets trending upward are even worse than markets trending downward.  They will both lead to losses in a market neutral strategy, but the advantage to downtrending markets is that each subsequent Iron Condor trade is opened with increasingly higher implied Volatility.  This makes the follow up trades progressively stronger. 

With markets trending upward like we've seen recently, each subsequent trade layer is opened with increasingly lower implied Volatility.  This narrows the wings and reduces the probability of success.

Essentially, strong trends in either direction will lead to stopped out Iron Condors, but downtrends will likely have fewer losses in a row before the the streak is broken.  Consistently up trending markets can suffer a longer streak of small losses.  Any one loss is no big deal, but as they say, death by 1000 paper cuts.

For Iron Condors, the trend is NOT our friend

If you were to tell me ahead of time that the stock market is about to go on a very strong uptrend, I could also tell you in advance that won't be great for the next several Iron Condors.  Given that we like to have 1-3 trades open at all times, I would fully expect several losing trades in a row.

Unfortunately I don't have a functional crystal ball, so all we can ever do is stay consistent, keep laying those trades, and on the rare occasions that the stock market goes on an epic run, we'll just keep our stop-losses tight and minimize the damage as much as possible.

3)  Can anything be done to right the ship?

This will be short and sweet, but the answer is no, absolutely not.  There's nothing fundamentally wrong with the strategy, it's just one of those rare market environments that will make it impossible to stay within our desired range.  The solution starting today is the same as it's always been since the strategy launched 12 years ago.

-  Continue using wide wing Iron Condors to maximize margin for error

-  Target long dated contracts to keep the Delta/Gamma low

-  Use only broad indexes and ETFs to limit outsized price moves

-  3% allocation size so individual trades are small

-  50% stop loss so losing trades don't stunt progress

-  Up to 3 trade layers to spread out the risk

-  5 point diversification:  Price, Time, Strategy, Volatility, Asset class

If any of that is foreign to you, that probably means you haven't had a chance to go through the 30 video Iron Condor Course available to all subscribers.  Remember, all our courses are available in your library.

I suggest you make your way through the course, as our Iron Condor Strategy is one I can confidently say will benefit ALL investors.