Boosting Your Risk-Adjusted Returns By Selling Options

Introduction

In this article, we're going to discuss how you can optimize your short strangle option selling strategy by finetuning the criteria of what underlyings to use, which delta to select, what duration you should look for and what management techniques we have to control our outcomes and reduce risk. It can always be very intimidating to get started with option selling, but here at OG we want you to realize that you can improve your risk-adjusted returns significantly by selling options, as long as you know what works well to achieve that goal.


1) What Underlyings To Select?

By far the most crucial aspect to becoming a successful option seller. Industry allocation, diversification and understanding the 'nature' of the stocks you sell options on make or break your success. If you sell options on less than 15 different non-correlated underlyings, your portfolio will be a lot more volatile than expected with mixed results along the way. Having on at least 20 different positions based on sound industry diversification increases the long-term win rate and makes your returns cluster around a mean, and rather static monthly return. The more occurrences we create, the better we can deal with unpleasant situations and make mid-term projections as to how much premium we can effectively pocket as profit.


In order to minimize directional risk, it's far better to sell calls and puts simultaneously so that if the stock starts moving against your 'no-bias' opinion, you can absorb short-term variance in your return and margin requirements. When being short premium, we're short Vega, a Greek which measures the price sensitivity of an option per 1% change in the implied volatility. The more volatile the implied volatility is, the more volatile and unpredictable your portfolio returns will be. Basically, we're looking for stocks that don't move that much: low-volatility stocks. There's a phenomenon called the low-volatility anomaly which underscores the outperformance of less volatile stocks relative to volatile securities on a risk-adjusted and absolute return basis.

We always talk about or concern ourselves with what stocks will provide the best returns over a long-term time frame, thereby often chasing a double-digit annualized return. That goes with high risk, but most people firmly believe you get compensated for that. In reality, however, from a buy-and-hold perspective (and trading perspective as well since it introduces more emotional investment decisions), taking on higher risk ultimately comes at an unpleasant price. By focusing on more risk, we lose the edge of risk/reward. Why is that? Research found that there's a negative relationship between risk and reward.

From 1990 to 2011, the tenth decile of a basket of all US stocks posted much worse returns than their least volatile counterparts courtesy of fickle cash flow generation and destroying shareholder value. The least volatile stocks perform much more consistently as their cash flows are stable and their sales growth moderate. They are somewhat overlooked as very few investors have high expectations of them when it comes to posting fast and dazzling profits. Who wants to invest in boring utilities whose cash flows are being regulated and whose debt-funding system provides a lot of visibility? Instead, you should chase the newest hype and pick the next tenbaggers. Nobody has a crystal ball, but the more consistent your returns are the better you will fare during the next correction/bear market. It's about winning by not losing.

As you can see from the graph above, the higher your beta is, the more you negatively skew your returns while taking more risk. Fooled by a feeling of getting rewarded handsomely, it turns out that our chances of sustainable investment success actually decrease noticeably if we choose high-risk investments.

This holds true in every country's equity market, as shown in the graph above. Low-volatility stocks produce double the Sharpe Ratio of high-risk equities by producing 25% higher returns while being 25% less risky. So, they beat the benchmark not only on a risk-adjusted basis which I believe most investors would have guessed easily (otherwise we wouldn't call them low-risk investments), but also on an absolute basis. There are, however, times when this type of factor investing will go through periods of underperformance. Lagging the broader market during market rallies by posting flat, slightly negative or less positive returns. Here's when our option selling strategy starts to kick in to create a wide profit zone wherein we make money if price changes are muted.

Low-volatility stocks are less volatile, but offer opportunities for option sellers as their historical volatility is still being overstated. That difference is known as the Variance Risk Premium. While the VIX, a proxy for the S&P-500's implied volatility, is very unpredictable and can explode from time to time, the IV for low-volatility stocks is a lot more stable. Especially this year, low-volatility stocks didn't suffer from the May and August corrections as did the S&P-500. Stabilizing IV, stable price action and good liquidity in low-volatility stocks such as NEE, AMT, DHR... present opportunities for the smart option seller.

Before investing in the VRP, or any strategy that exhibits negative skewness, you should be aware that, while such strategies can consistently accrue small and consistent gains over many years, rare, large losses disproportionately occur in bad times. It’s this poor timing of losses that helps explain the large required risk premiums. For example, a simple strategy that involves capturing the S&P 500 volatility premium lost more than 48 percent in October 2008. However, volatility premium strategies tend to recover quickly, more so than other asset classes, because it is precisely in the immediate aftermath of a crisis event when the implied volatility is highest (caution: a high implied volatility doesn’t guarantee a high return as realized volatility can continue to increase). This is similar to how insurance companies, which raise premiums after incurring large losses from catastrophic events, operate. Again, selecting individual stocks that see moderate monthly price changes is a better strategy than just utilizing the benchmark (SPY tracker) . This is especially true if you recall that the IV for the S&P-500 and other major indices is hovering near one-year lows. You're now selling cheap options with a low chance of success, which isn't necessarily the case when opting for individual low-volatility stocks! Some people sell options on futures, but that's way too risky for the individual self-directed investor...

Here's where selling premium on low-volatility stocks combines the best of both worlds: less drawdowns compared to an ordinary ETF and consistent implied volatility. Let me clarify this statement. Below you have the implied volatility chart for Danaher, DHR. We see moderate fluctuations in IV and a lot of occurrences around the 50% IVR, so we're able to sell premium when it's rich. To put some context around that, we recently sold 125/155 strangles on DHR expiring on January 17th, 2020 for 142 dollars per contract.

If you were to sell premium on NVDA, which is a very volatile underlying, you'll get few occurrences, huge spikes in IV and more outlier risk. Not the sort of elements I was hoping for as a conservative option seller. To put another way, although high-risk stocks offer juicy premiums, the risk is much more elevated if we get a huge move, either way up or way down.

Looking at more defensive, low-volatility business areas, our watchlist is now composed of the following sectors:

2) What Delta And Duration?

There's one golden rule when selling options on low-volatility stocks: giving yourself adequate duration to reduce gamma risk, pocket enough credit and roll out when required. The concept of selling premium boils down to a trade-off between Return On Capital (ROC) , time decay and duration. The more days to expiration, the higher the premium, but that goes with slow time decay. In other words: not enough bang for our buck (a small daily return relative to the amount of capital we have to come up with). If you focus on shorter durations, option prices are more sensitive, but you get rapid time decay on a small amount of credit. It's therefore important to opt for reasonable duration, decent ROC and width between the put and call strike.

(Source: Tasty Trade)

Let's consider PG for a second, a security on which we sold 110/130 short strangles with January 17th, 2020 as expiration date. We collected 88 dollars per strangle (one option is the equivalent of 100 shares) and it's now trading anywhere around 70 dollars. If we were to sell the 117/126 strangle expiring on December 27th, 2019, we get 103 dollars per contract but the width has narrowed considerably. If PG starts moving either way up to 126 dollars or way down to 117 dollars, we are going to get hit hard on that short-term trade. A 10-delta strangle results in an attractive ROC and high win rate. If you sell a short-term strangle it's more margin consuming than a longer-term one because of the difference in strike prices. Of course, in return, time decay is nil for long-term options. Finding a balance between margin, premium and time decay is a subjective exercise.

More time until expiration allows for the same credit, with a higher chance of success.

3) Management Techniques

* Rolling Out

One of the risks as an option premium seller is a sudden spike in IV just after you sold options. Let's say you hypothetically lose 0.5% of your portfolio value when IV rises 1%, but collect 0.15%-0.20% in daily theta. If low-volatility stocks have see a 5% surge in their IV over a one-month period, you would have lost 2.5% but collected way more in daily theta. Thus, net-net, you're still up for the month.


Increased volatility also caused the option premia for the next months to increase sharply. As such, it's critical to roll out your positions at 30-25 days before expiration, re-center your strikes and again extend duration to 60 days. Consequently, we now have rebalanced our portfolio and reduced risk. Based on the IV curve, longer term options pricing is oftentimes based on a higher IV, as shown for American Tower, AMT.

If we face heightened volatility (like in 2008), we can decide to roll out even further (by extending duration to 4 months for example) and widen out the strikes (we then get in excess of 50% of downside risk protection). That's when we're really cautious about the market and don't want to incur huge short-term losses. As the situation starts to normalize, we can re-enter our shorter-term short strangles while still benefiting from above-average implied volatility and wide profit zones.


* Rolling The Untested Side

If one side gets breached, it would normally be at the end of your holding period (after one month, I'd like to roll out the position) which means that you won't have lost/gained money on that position that month (in case of a decline, the puts will have tripled in value, while the calls are worthless, net you have double the put premium to buyback which is roughly the equivalent of one call and one put). To put some context around that, I currently have on the 210/250 strangle in NEE. That stock has to fall by 10% in one month before I start incurring losses on that position, because by that time a lot of time decay has already eroded both the put and call value. So, as long as price changes remain moderate we collect net time value and then roll out the position. It's hard to say how much you eventually realize as profit. My goal is 50%-65% over a one-month time frame utilizing 60-day options. If one side gets breached before the date of rolling, roll the untested side and check on the contract size and importance of that position for the portfolio. In short, don't over-allocate to one position no matter how great the opportunity might be.


For example, ATO one of the names we sold options on has depreciated 4% since selling options on it as we saw a shift from boring utility stocks to exciting securities. The impact on our portfolio over that time frame (one week and a half) ? 0.07%, which has been easily made up for by other positions. If you just owned the stock instead of selling strangles on it, you were down 0.20% assuming you have 20 different positions. However, from a risk management standpoint, I decided rolled down my calls from 115 to 110; the put strike is 105. As a result, I collected more premium on the call side and used it to reduce my strangle size. I bought back the calls for a decent profit and used it to buyback some puts that were at a loss. Consequently, no change in my cash position but my exposure to the downside on ATO shares has been reduced by 50%. Just a way of managing risk. Another big advantage of only selecting low-volatility stocks for your short strangle portfolio is that your margin requirements can be kept under control as price changes are smaller.


I hope you liked this article and take the time to read our latest Seeking Alpha contribution in which we highlight the first 10 stocks we like a lot for our short strangle strategy. Stay tuned for more articles and information, check out our subscription service & follow up our track record that is going to be completely updated next month. Our mission is clear: targeting decent returns while achieving far better risk-adjusted returns than the benchmark.

Option Generator AM

Company number: BE 0750.963.805

©2020 by Option Generator - All rights reserved