An Options Case Study that Compares 90% Probability Against 70% Probability
Index Iron Condor and Credit Spreads Options
There are many index iron condor & credit spread options advisory newsletters on
the market today. Iron Condors are popular because they are relatively
easy to understand, they don't require options analysis software to visualize,
and they generate an excellent monthly income of 6% to 10% ROI per month.
Most Index iron condor & credit spread newsletters fall into two camps, either
recommending 70% probability trades or 90% probability trades. Monthly
Cash Thru Options primarily focuses on 90% probability trades because we believe they
represent the best balance between risk and
reward, and they provide an excellent 45% to 65% annual ROI. Many competing iron
condor newsletters that use 70% probability trades will lead you to believe that
their strategy is superior and they
usually simplify their argument by only focusing on the amount of risk capital
per trade. Our competitors also state that 90%
probability iron condors represent a “high-risk,
low-credit” type of strategy. Reality is that both 70% trades and
90% trades will work, but one needs to dig deeper into the analysis of both approaches.
This article proposes a more thorough methodology to analyze the risk associated
with 70% probability iron condors versus 90% probability iron condors, discusses
the pros and cons of each approach, attempts to dispel possible misinformation
in the marketplace, and makes a case that 90% trades offers the best risk/reward
tradeoff with the least amount of stress and work.
When defining “risk” for credit spreads and iron condors options, most
experienced credit spread traders will agree that risk comprises many
components. Two of the more important components are 1)
Probability of the credit spread going in-the-money (ITM); and 2) The risk
versus potential reward of the trade. Additional risk related factors that
should be included and that many times are omitted are the following: 3) The
amount of time and effort required to monitor and manage the trades; 4) The
amount of time available to react to a fast moving underlying security giving
the trader sufficient time to make adjustments if needed; 5) The average number
of times per year the trades get into moderate danger, that is they get close to
going ITM, causing stress and uncertainty for the trader; 6) The average number
of times per year that the spreads get into high danger requiring the trader to
close out the spread or make adjustments, causing a losing month; and 7) The
average % loss for each of the losing months per year.
Using an example of a 10 point spread, and doing an apples-to-apples comparison
by analyzing a single credit spread, let’s look at both a 70% probability trade
and a 90% probability trade in more detail. The 1.3 standard deviation, or 90%
probability credit spread has a 9 to 1 ratio where the trade risks $9 to make
$1, it shoots for an approximate 11% return, it has a 90% probability of
expiring OTM and profitable, and has a 10% probability of getting into trouble
and going ITM. The 1.0 standard deviation, or approximate 70% probability
credit spread has an 8 to 2 ratio where the trade risks $8 to make $2, it shoots
for an approximate 25% return, it has a 70% probability of expiring OTM and
profitable, and has a 30% probability of getting into trouble and going ITM.
In order to analyze these two scenarios in more detail, we need to take into
account the additional risk related components that we discussed above. From
data that we’ve extracted from several iron condor services, and through our own
experiences of trading both types of iron condors, we’ve observed the
following:
90% probability iron condors tend to have on average 9 to 10 profitable
months/year, and 2 to 3 losing months/year with typical losses of 10% or less.
Per the level of workload and stress involved, 90% probability trades tend to
have 6 months of low stress where they make easy money, 3 to 4 months of
moderate stress where no adjustments are required but some of the spreads get
under pressure and have to be watched closely, and 2 to 3 months of higher
stress and workload where they will have a loss and adjustments are required to
keep the loss below 10%.
70% probability credit spreads tend to have on average 7 to 8 profitable
months/year, and 4 to 5 losing months/year with losses usually 10% or less. Per
the level of workload and stress involved, 70% probability trades tend to have 3
months of low stress where they make easy money, 4 to 5 months of moderate
stress where no adjustments are required but some of the spreads get under
pressure and have to be watch closely, and 4 to 5 months of high stress and
workload where they will have a loss, and adjustments are required to keep the
loss below 10%.
Below is a grid that summarizes the characteristics of each approach, and one
might come to the conclusion that both strategies can work. In actuality, both
strategies can work and each strategy returns about the same annual returns over the long run, but the big difference is that the 70% trades come with
higher volatility, stress, required work, and risk of getting hit with a big
loss if the underlying security moves quickly.
From looking at the chart above some traders prefer the 70% probability iron condors that comprise both a bear
call spread and bull put spread that shoot for a 25% to 40% return in 30 to 45
days and they accept the fact that: 1) There is about a 40% probability, or
about 4 to 5 months/year that their iron condor will get under pressure causing
a moderate level of stress and requiring additional time to watch the trade
closely; 2) They accept the fact that there is a 30% probability, or about 4 to
5 months/year that their iron condor will get into high danger by a quick moving
underlying index resulting in a high level of stress and a higher work load to
make adjustments to minimize the loss for the month; 3) And investors that
embrace 70% probability iron condors are ok with the fact that because of the
higher probability of the iron condor going ITM causing a large loss, they
should allocate no more than 5% of their portfolio to any single trade. As a
result, the trader will need to spend time researching and opening additional,
non-related trades to put their available capital to work.
In contrast, some traders prefer the 90% probability iron condors that shoot for a
10 to 15% return in 30 to 45 days and they like the fact that: 1) There is a
high, 90% probability that the iron condor will expire OTM and profitable, and
as a result there is less work & time involved, it’s more hands-off, the trader
sleeps better at night when the market gets volatile, and it's a good fit for
people with a day job; 2) There is low stress about 6 months per year when the
90% probability trades generate “easy money”; 3) Traders that embrace 90%
probability iron condors accept the fact that there is about a 20% probability,
or about 3 to 4 months/year that their iron condor will get under pressure
causing a moderate level of stress and requiring additional time to watch the
trade closely; 4) There is a 10% probability, or about 2 to 3 months/year that
the iron condor will get into high danger by a quick moving underlying index
resulting in a higher level of stress and workload to make adjustments to
minimize the loss for the month; and finally... 5) The experienced traders that
have 2+ years of experience with index credit spreads & iron condors can
leverage 90% probability trades to allocate up to 75% of their portfolio into
this single strategy where they don’t have to trade any other strategies if they
don’t desire or have the time.
In summary, both strategies can work since they both return, at least over the
long run, about the same ROI, but the 90% probability trades come with less
volatility, stress, work, and less risk of taking a large loss if the underlying
moves quickly. Moreover, 90% probability trades are more hands-off, the
trader will sleep better at night when the markets get volatile, and it's a
perfect strategy for people with a day job. This is why Monthly Cash Thru
Options primarily leverages 90% probability trades.
About The Author
Brad Reinard is Editor-in-Chief of Monthly Cash Thru Options LLC, a leading
index credit spread & iron condor options advisory newsletter, which has the
following track record: 92% 2009; 33% 2008; 63% 2007; 42% 2006; 50% 2005. For
more information on the technical analysis that we perform on the S&P 500 and
Russell 2000 (RUT) indexes, along with how to trade trading tips on iron condors
and credit spreads please visit
www.monthlycashthruoptions.com or call Brad directly toll-free at
877-248-7455. Monthly Cash Thru Options LLC is located in San Jose, California,
the heart of Silicon Valley.
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