What’s better 90% or 70% Probability Iron Condor and Credit Spreads Derivatives?

This derivatives case study analyzes the pros, cons and risk between 70% and 90% probability iron condors and credit spreads options.  It attempts to dispel possible misinformation in the derivatives marketplace about this options trading strategy, and it makes a case that 90% probability trades offer the best risk/reward tradeoff with the least amount of stress and work.

By Brad Reinard, Editor-in-Chief, monthlycashthruoptions.com
Last Update August 19, 2009

There are many newsletters on the market today that teach investors how to trade index iron condor & credit spreads, where many open derivative trades on the S&P 500 and Russell 2000 (RUT) indexes.  Iron condor options are popular because they are relatively easy to understand, they don’t require options technical analysis software to visualize, and they generate an excellent monthly income of 6% to 10% ROI per month.   Most newsletters that teach how to invest in index iron condor & credit spreads 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, require the least amount of work, and provide an excellent 45% to 65% annual ROI.  Many competing  newsletters that teach how to trade 70% probability iron condors will lead you to believe that their derivative 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 and credit spreads 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 derivatives 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 derivative 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 derivative 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 credit spread derivatives 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 spread derivatives 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 derivatives 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.

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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:   69% YTD 2009 (thru Aug); 33% 2008; 63% 2007; 42% 2006; 50% 2005.  For more information on how to invest in S&P 500 and Russell 2000 (RUT) index derivatives, along with rules on how to trade these instruments, 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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