Correlation And Short Vega: Let's Do The Math!

Updated: Oct 29, 2019

Correlation: Diversification Makes The Most Sense For Premium Sellers

Selling strangles is always referred to as being risky as we have downside and upside risk. However, we can actually throw the odds into our favor not only by enjoying high probability of profit (a realized 90%+ for 10 delta strangles, versus 55% for buy-and-hold investing) but selecting different, non-correlated assets to keep our portfolio volatility to a minimum. If you are a common stock investor, spreading the risk via purchasing bonds and stocks does reduce your standard deviation, but it doesn’t provide you with additional returns as bonds and stocks show strong negative correlation (they are counterparts that will smooth pronounced movements out). But what about selling short strangles on these assets? Can we reduce our risk by setting up delta-neutral strategies with wide profit zones, regardless of whether we were wrong or right about the direction (let’s say you are bullish on the SPY and bullish on TLT, can you make enough money if you’re completely wrong about their future price action?) By selling strangles on the major American indices from 2005-2018, we did post smoother returns.

Looking at the ETF correlations, things get even better…

By selling 1 SD strangles (16 delta on each side) on all sector components, we significantly reduced our correlation to the S&P-500 whereas buying them outright doesn’t provide you with additional returns or lessened volatility. This is really cool and it’s the primary reasoning behind why I have on a cell tower REIT position, storage REIT, Chinese and American e-commerce underlyings, software company, air-conditioning manufacturer, medical equipment producer et cetera. Buying healthcare companies outright resulted in a massively positive correlation of +0.80 to the S&P-500, but by selling wide strangles there's almost no remarkable correlation (we now sell 10 delta strangles so the relationship between healthcare and the entire market performance should disappear completely). This makes total sense from a risk management point of view, yet very few investors pay attention to it and look at just the beta values alone.

Short Vega

When selling delta-neutral strangles, we benefit from time decay (a pretty predictable metric during the first three weeks of the contract period) and volatility collapse. But what if the market turns volatile, causing our short options to increase in value and thus resulting in temporary losses for portfolio even if we haven’t yet breached one of our strikes (rising volatility can also happen when markets go up)? How can we mitigate the impact of rising volatility on our portfolio?

  • Adding short delta to your portfolio, which will help offset higher implied volatility if markets drop

  • Keeping your size under control when volatility is low so that we can scale up in high IVR environment

  • Rolling out at 21 DTE regardless of our financial result, so that we add short Vega to the portfolio when IVR gets really high as longer term options are more sensitive to changes in IV.

But what are the actual results in a downturn when volatility spikes? Let’s review the period of Octover-December of 2018 to scrutinize the impact of higher volatility and whipsawing stocks. Is there a way we can navigate through these situations when shorting premium? Tastytrade once gain conducted a study focusing on 25% capital usage for short strangles.

Selling the 10 delta strangle resulted in a loss of 7.3% during the fourth quarter of 2018, noticeably better than the -16.4% for the SPY. This is when managing early. But I wanted to dig deeper into the actual options prices when you sold premium in SPY, BABA and SBAC when managing @ 21 DTE (since there was a downturn with devastating velocity in December, managing winners @ 50% was almost impossible courtesy of IV expansion). The 50% IVR for the SPY during 2018 was 17%; 23% for SBAC and 41% for BABA. That means that starting out in early October wasn’t an optimal period and if we see higher implied volatility, we should opt to scale up to maximum 50% of our capital because big opportunities present themselves when there’s a lot of fear baked into options prices.

So let’s take a look at selling premium in BABA, SPY and SBAC starting on October 1, 2018 until January 22, 2019. So, let’s sell 10 delta strangles (no skew) with 45 DTE, managed @ 21 DTE. BABA is the one highlighted below (red numbers indicate the cost to buyback the old strangles while green ones show the cash inflow). Every time, at 21 DTE, we rebalance our deltas to recenter our risk and exposure to the underlying. Please note that December 28 should be January 7, 2019 but the results remain the same.

Net profit of $641 per short strangle, using $1800 margin, which means that if your account size is $7200; you’ve generated a net return of 8.9% in 4 months or an annualized 26.7% with 25% of your account size, while the ordinary investor buying BABA at $162 lost 6% over that same time period. This result is just awesome considering the amount of elevated implied volatility and two-sided market action. It also highlights that even when volatility spikes (and thus adversely impacts our profits) we are able to absorb this by constant time decay and conservative strike price selection. Next time, I’m going to address a stable underlying and ‘boring’ growth REIT namely SBAC and how it fared during that same October 2018 - December 2018 melt-down.

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