The Role of Probability when Trading Iron Condors

Hi Mark:

Thanks for the posting. After reading so many reader's question, I am
curious about how you personally see this thing: The role of
probability in option trading.

Just as we discussed last time – the market return is actually a
"fat-left tail bell-shaped distribution" (Ok, similer to normal
distribution but not exactly). So, it means that, a "market direction
neutral" strategy is possible, given the probability distributions of
the broad market return have been relatively very similar across time.
Just by strict risk control, is "trading probability" an feasible way
to survive in the market???

Personally,even though I do see a lot in probabilities, the
"expected value" is never in my trading plan. I know too well that,
when, the tail risk happens,even if, I do spreads, and as long as I put
all of my eggs in one trade,then I am still a dead body — this has
nothing to do with "expected value". So my biggest plan is always
ex-ante risk control.

Thanks in advance if you can share your view on the "probability trading" way.




It's not just probability.  It's also about profit potential. 

You cannot evaluate whether to accept a specific probability of success without knowing how much can be earned.  That's why I try to find a compromise between going as far OTM as possible (HIGHEST probability), with a GOOD profit possibility (not too far OTM). 

No risk is worth taking, no probability of success is high enough when the reward is too small to justify the risk.

In short, I don't dwell on probability.  But that's because the option's delta already provides a good picture of probability (of a sold option expiring worthless) and I already took it into consideration when choosing my strike prices for an iron condor trade.

As you note, we do have a fat tail problem on the left (down) side of the curve.  I take care of that problem in one of two ways.  I can trade less size (my current method), or I can buy insurance (which I prefer, but I only do that when option prices feel reasonably priced).

I am content to trade less size and keep cash in reserve because it reduces stress and allows me to adjust a trade with less pressure (threatened loss is less).  Sure, the profits may be reduced, but that's the trade off.

As a side comment, this has been working well.  June and July were my two best months since I trading iron condors, and even with reduced profits, I am satisfied.  My results were far worse earlier in the year when I was trading more size.

Henry – if you are protected from being killed, that's a good thing.


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7 Responses to The Role of Probability when Trading Iron Condors

  1. Henry Tzuo 08/11/2010 at 8:42 AM #

    Thanks Mark. I see. 🙂
    Henry Tzuo

  2. Kim 08/18/2010 at 2:43 PM #

    You mentioned couple of times that you usually hold insurance against black swan event. I would be interested to know what kind of insurance do you carry – straight puts, spreads, expiration time etc. What percentage of your portfolio per month do you spend on this insurance? I understand that there is no one right answer for this question, but I would like you to share your view since I find myself agree with more than 90% of your general trading philosophy.
    Thanks a lot for your great blog!

  3. Mark Wolfinger 08/18/2010 at 4:14 PM #

    Hello Kim,
    I don’t always hold insurance, and don’t have any right now. The truth is that it is very expensive when IV is elevated. I manage risk by keeping position size smaller and covering OTM spreads when they get to 15 or 20 cents.
    More details tomorrow in a full blog post.

  4. Chris Boerema 08/22/2010 at 9:05 AM #

    Thank you for the effort you make in keeping this blog.
    Now I’ve been pondering on the following matter this weekend, if you can spend the time, could you comment my line of reasoning?
    For the role of volatility in options pricing: As a rule of thumb, volatility of any underlying stock or index jumps upward if the underlying is down, much more so if it is down a lot in a short time. A steady increase of the underlying makes volatility shrink and only a very sharp raise of the underlying makes the volatility move upward, but not sharply. Please comment if this is incorrect, as a rough rule.
    I am inclined to see an asymmetry in this rule of thumb, I guess this makes volatility the parameter in options pricing that makes puts yield more premium than calls.
    Does this imply something for choosing strikes of Iron Condors or short strangles? Say an index is at 330 and has been moving up and down for some while between 305-310 and 345-355 zones. I want to sell an IC at 290/300 put side and 360/370 call side, say 5 contracts, 2 months out. Now as a scenario, if the underlying would rise steadily, the short call 360 comes under pressure, but only gradually. The increase in price for the 360 call is offset to some extent by the volatility of the underlying seeping away.
    Not so for the put side. As a scenario of this index dropping in a likewise steady pace, would come with a raise in volatility. The short put 300 would rise more rapidly in price. This makes protective actions expensive, say buying a 305 put with this 5 lot IC, or closing the entire position on the put side.
    Would it be recommendable as a general rule to set up IC’s that seem asymmetric at first glance? Above example, underlying 330, call side remains 360/370 but the put side choose 280/290 or even lower. In terms of the probability that either the short put or short call is reached, this position would actually be more symmetric. I feel making my IC asymmetric offsets the asymmetry of volatility reacting to a respective rise or drop in underlying and the influence of volatility on prices of puts & calls.
    Is this a recommendable general rule or do I miss anything?
    Thank you, Best Regards,

  5. Mark Wolfinger 08/22/2010 at 11:22 AM #

    Your generalizations are correct and you are not missing anything.
    I think this topic is worth expanding – and I’ll respond in a blog post this week.

  6. Jorge 09/01/2010 at 4:37 PM #

    Hello Mark,
    Thank you very much taking time to respond to people’s questions and giving your experienced points of view.
    I started selling cash covered puts and buying covered calls. I didn’t lose money but I wasn’t very successful either, mainly due to my inability to determine market direction and my account size, only 8k. I realized that I needed more capital to view gains big enough to justify the time spent doing research and follow up. However, I then found the great IC strategy and I felt in love quickly, non-directional strategy and nice returns.
    The only problem is that my account size doesn’t give me much room to work with adjustments once the trade is open, margin locks up most of my capital. Do you have any suggestions on what type of percentage should I invest and what percentage I should keep for adjustments? I tried trading SPY with 2 point spreads, but the credit collected is not big enough to close the position early and forces me to keep the trade open for longer than I would want to. However, moving to bigger indexes like SPX or NDX would mean to trade 1 or 2 contracts and would not leave room for stage adjustments, like closing 20% then 30% then 50%.
    Thanks again.

  7. Mark Wolfinger 09/01/2010 at 6:22 PM #

    My pleasure, and please keep those questions coming.
    Reply as a separate post: Sept 4, 2010