In this week’s newsletter, I wanted to dig deeper into correlation and how 9 different positions active in various sectors (cloud, e-commerce, storage, cell towers, air conditioning systems, financial transaction services, health insurance companies, chemical gas producers…) are correlated to each other. As I highlighted earlier, selling wide strangles actually reduces correlation even further as we don’t have a directional bias and capture time value. Below you find the correlation of the cumulative daily returns over a 1-year period (Oct 2018- Oct 2019). We notice that air conditioning producer Lennox is less correlated to storage REIT Public Storage which means that if one of them drops, it doesn’t necessarily affect the other one’s performance. Likewise, cell tower REIT SBA Communications is not strongly positively correlated to Alibaba. This is a crucial component of your overall portfolio positioning.
Generally speaking, we as option sellers (in particular, short strangles) want to keep our delta as close to zero as possible to avoid having a directional bias that works out badly for our position. But, what about adding short delta when volatility is really low? When markets go south, our zero delta turns ‘long’ meaning that the short puts of our strangles increase while the short calls don’t offset this anymore. Additionally, since markets are dropping, volatility increases causing our short premium to increase in value. If we add short delta to the portfolio (on stocks that have a higher beta) when volatility is low (as of today that’s surely the case), we can digest not only a drawdown, but also the adverse impact of elevated volatility on our short options. Why is that important? It reduces your portfolio volatility and eventually, as time goes by, you’ve still collected a sizeable amount of positive theta. Being short delta (in my opinion you have to do it when volatility is low and you have to ‘handle it with care’ because you don’t want to be too much short delta when markets rally) offsets the effects of being short Vega. For instance, if your portfolio Vega is -$1,000, then it would pay to have a negative delta of -$200.
To put more context around this, as of today, our ADBE position has short delta of $101 with $222 of short vega. If ADBE shares drop 3% (an 8 dollar down move) volatility would spike by let’s say 2%. Since I’m short delta of $100, I gain $800 which is offset by a loss $444 because of short vega while generating another $79 in positive theta. As the price goes down, our short delta will decrease and might turn positive if we see a sharper selloff. All in all, it’s all about reducing your potential losses (because of severely negative market sentiment along with higher volatility priced into our short options). Let’s say that volatility goes up by 4% on a monthly basis and we are short vega $222 but collect $79 in positive theta, all else being equal, we would need 11 days to make up for the increase in volatility. Though, when volatility starts to mean-revert (which it always does sooner than later), our short vega then starts to contribute positively to our overall P/L. Luckily, we always have positive time value to overcome periods of higher implied volatility. That’s the primary reason why I’d like to sell premium, especially when it’s rich (IVR of 50%). If volatility is at the lower end of its range, selling short delta is going to smooth out drawdowns and short vega. Your portfolio then solely relies upon positive daily theta. And fortunately, that metric is a lot more predictable…
Back in September of this year, Tastytrade’s research conducted a study on the cumulative performance of selling 1 Standard Deviation (16 delta) strangles with 45 DTE from 2005-2018. Rolling @ 21 DTE achieved not only a higher P/L, but the results were a lot more consistent compared to doing nothing and thus holding your strangles until expiration. This does not take into account managing @50% and as earlier studies have pointed out more than once, the combination of managing early or managing @ 50% - whichever comes first – creates more opportunities and occurrences to manage profitable trades.