Crashes haunt the dreams of investors. But not all strategies suffer the same when bears usurp power to sit on the throne. Some, like the Cash Flow Condor system, arguably fare equally well in bull and bear markets. The reason lies with volatility and market efficiency.

Let’s tug on this thread a little further.

Iron Condors are almost a pure play on volatility (vol). They would be a real pure–play if you dynamically hedged to keep the delta at zero, but most traders don’t do that. So we’ll have to settle with the description of an “almost” pure play. To fully flesh this out, a quick review of definitions is in order.

Realized volatility: The actual volatility exhibited by an asset over a specific time frame. Also known as statistical vol or historical vol.

Implied volatility: How volatile options premiums are implying an asset will be in the future.

Here’s one way you could think about condors and profits.

If realized vol < implied volatility, then condors win!

If realized vol > implied volatility, then condors lose!

Condor Profit Formula

The reason Cash Flow Condors has an edge is because in the past realized vol has been consistently less than implied vol. And unless human nature changes (it won’t), this edge will remain.

This is true (that is, the edge exists) in bull markets and bear markets – because of market efficiency.

Here’s an undeniable fact for you. Bear markets are more volatile than bull markets. Usually much more so. But that doesn’t mean they necessarily kill condor systems.

Why?

Because implied volatility goes up too! Realized volatility is real risk. Implied volatility is perceived risk. When real risk rises, perceived risk rises. And that’s a good thing because it allows you to sell iron condors with much wider profit ranges.

A Tale of Two Condors

Remember, we want the market to be range bound for condors to generate profits. Fortunately, due to the low deltas we use, the range can still be quite wide.

Let’s say the S&P 500 has a historical volatility of 8. We’ll assume a 30-day reading because that’s what most people use. The real risk has been low. In other words, market movements are muted. At the same time, the VIX (aka implied volatility) is 12. Perceived risk is low too. In this environment, you won’t be able to build an iron condor with that wide of a profit range. But why should you be able to? The risk is low, so you don’t DESERVE a wide range.

One quarter later, a bear market strikes, and historical volatility roars to 25. The real risk is now juiced because, well, the market is bananas. Can you guess what would happen to the VIX? It would shoot to the moon. Let’s say to 30. Perceived risk is now sky-high. In this environment, you will be able to structure a condor with a wide range. And justifiably so.

The scariness of deploying condors in a volatile bear market is offset by the fact that you’re able to go much further OTM to build your bird. Thus, the edge remains.

Remember this next time the market goes kablooey!

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