Short Iron Condor

This project evaluates the Short Iron Condor strategy applied to Reliance options from August 2021 to July 2024. The methodology involved calculating ATR, selecting strike prices based on volatility, and assessing performance using Zerodha's margin calculator. Profits, costs, and interest were analyzed to measure the strategy's effectiveness across various market conditions.

Introduction

The project centers on the implementation of the Short Iron Condor strategy for Reliance Industries. The chosen period, August 2021 to July 2024, covers significant market events such as the post-COVID-19 volatility and the ongoing geopolitical tensions from the Russia-Ukraine war. These events influenced volatility and trading patterns in Reliance stock, providing a rich dataset for the backtest.

Methodology

The primary objective of the strategy is to earn a profit when the price of the underlying asset, Reliance, remains within a specific range. The methodology used for this strategy revolves around the Average True Range (ATR) to determine the strike prices of the options involved. The key steps involved in the methodology are:

Data Collection: Reliance's daily closing prices were collected from the NSE, along with near-month call and put option prices (those expiring within 30 days). The margins required for the strategy were calculated using Zerodha’s margin calculator, and interest costs were factored in using the 1-month MIBOR rate.
ATR Calculation: The ATR is calculated using a 22-day rolling window to capture monthly volatility. The formula involves calculating the true range (TR), which is the highest value of three components: the difference between the high and low prices for the month, and the absolute differences between the high/low prices and the previous month’s close. This process is repeated monthly to adjust the strategy’s positioning.
Strike Price Selection: The short call and put strikes are placed one ATR above and below the spot price, respectively. To account for potential market volatility and tail risk, the buy legs are placed 40 points away from the sell strikes. The positions are held until expiration without early squaring off, and profits are realized at expiry.
Margin and Interest Calculation: Margins were calculated through Zerodha’s tools, and transaction costs were considered. The interest on the margin was calculated using the MIBOR rate to simulate realistic cost implications.

Here's the final model :

Derivatives

Key Assumptions

To manage risk, the strategy was conservative in selecting strike prices. Both call and put strikes were rounded up or down to avoid unnecessary exposure, and the buy legs were placed 40 points away to provide a cushion against extreme movements, especially given RIL’s potential for large rallies.

Performance Evaluation

The strategy was evaluated on a monthly basis, with the profit and loss (P&L) recorded as a percentage of the initial margin. Notably, the strategy was designed to capture small gains by keeping the stock price within a relatively narrow range. It fared well in low-volatility months, but underperformed during periods of high volatility, such as those triggered by the Russia-Ukraine war and post-COVID-19 recovery.

Monthly Returns

The analysis used both the Average True Range (ATR) and the Max True Range (MTR) for strike price selection. It was found that:

The ATR-based strategy delivered more consistent and higher returns compared to the MTR-based approach. This is because the premiums were higher closer to the At-the-Money (ATM) strikes, and as positions moved away from ATM (under the MTR strategy), the premiums became insufficient to cover the transaction and interest costs.
The MTR-based strategy struggled with profitability, especially in low-volatility months. As the premiums for far-out strikes dwindled, transaction costs, brokerage fees, and interest on margins outweighed potential gains.

Findings and Conclusion

The Short Iron Condor strategy yielded positive returns in most months, particularly when market volatility was moderate. The strategy capitalized on the periods from 2021 to 2023, where post-COVID volatility and geopolitical events like the Russia-Ukraine conflict led to higher premiums and more favorable trading conditions. However, in recent times, returns have diminished due to a combination of lower premiums, reduced volatility, and rising interest rates. Key findings from the analysis include:

ATR-based strike selection consistently outperformed MTR-based selection. The rationale was that the premiums near ATM strikes offered better returns relative to the cost of maintaining positions.
Impact of volatility: The strategy was most effective during times of moderate volatility. In periods of extreme volatility, losses occurred because the stock price exceeded the expected range, leading to unfavorable outcomes for both the short call and short put legs.
Transaction and Interest Costs: The margins and costs associated with the strategy were substantial, especially when volatility decreased and interest rates rose. These costs played a significant role in reducing the overall profitability, particularly in 2023-24.
Volatility Peaks: The strategy saw its best performance during the high-volatility period following COVID-19 and the early stages of the Russia-Ukraine war. However, with diminishing volatility and rising interest costs, the overall returns from the strategy have decreased.

Recommendations

Given the insights from the backtesting, the report recommends:

Continue to employ ATR-based strike selection for low- to moderate-volatility environments, as this method has proven more effective in generating returns.
Adjust positions based on market conditions, particularly by tightening the range during periods of high volatility or exploring alternative strategies when market movements are unpredictable.
Monitor costs closely: The transaction and interest costs are significant detractors from overall performance. It is recommended that these costs be considered in future strategy refinements, potentially by exploring lower-cost brokerage alternatives or adjusting the holding period.

In conclusion, while the Short Iron Condor strategy delivered positive returns during most of the period analyzed, its profitability was highly sensitive to market volatility and cost factors. Adjustments to the strike price selection and a close eye on costs are essential to optimizing this strategy moving forward.

Thats it folks, this was a group effort (given we did this under 4 hours) there's are good scope to improve.

Scope of Improvement:

Dynamic Strike Price Adjustments: The current strategy applies fixed ranges for strike prices based on the ATR and a 40-point buffer. While this offers protection during volatile periods, it can reduce potential profits in more stable markets. Implementing a dynamic approach, where the buffer is adjusted based on real-time volatility trends or specific market conditions, could improve profit margins.
Early Position Adjustment: Holding positions until expiry limits flexibility, especially when market conditions shift unexpectedly. Introducing provisions for adjusting or closing positions early, particularly during periods of extreme volatility, could reduce losses and lock in profits more effectively.
Transaction Cost Management: Transaction costs, including brokerage and interest on margins, are significant detractors from overall profitability. Exploring lower-cost brokerage options, optimizing position sizing, and potentially using alternatives with lower margin requirements could improve the net returns from the strategy.
Consideration of Alternate Time Frames: The backtest used near-month contracts with expiries less than 30 days. Evaluating longer or shorter expiry periods, based on market conditions, may provide more opportunities to enhance returns. For instance, weekly options could offer better opportunities to capture smaller market moves, especially in low-volatility environments.
Incorporating Volatility Indicators: The strategy’s sensitivity to volatility suggests that using additional volatility indicators, such as the VIX or implied volatility of the underlying asset, could help in better timing of entries and exits. This would allow for more informed decisions on adjusting the strike prices or avoiding positions during excessively volatile periods.
Risk Mitigation with Hedging: While the strategy already incorporates protection with long call and put options, further exploration into advanced hedging mechanisms (e.g., delta hedging) could improve protection during high-volatility periods. This would minimize the adverse impact of large market movements on the short legs.
Monitoring Interest Rates: The increasing cost of margins due to rising interest rates has impacted profitability. A close monitoring of interest rates, and adjusting margin-intensive positions based on anticipated rate movements, could reduce interest costs and improve profitability.

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