Low-Volatility Stocks: Fewer Drawdowns, Smaller Price Fluctuations
I’ve learned three things last month: manage your winners no matter what (if you don’t, the relationship between risk and reward just worsens), diversify into more underlyings in different industries, focus on attractive underlyings rather than absolute premium and ROIC (Return On Invested Capital, thus premium/buying power reducation) and reduce your contract size if you have to roll the untested side… The following research pieces give us insight into the powerful statistical evidence of selling wide strangles, diversifying into several industries and why low-beta stocks are very attractive from a premium seller standpoint.
The new watchlist of 25-30 stocks I’ve composed just a moment ago, is made up of low-beta stocks that show a high IV/Hist. Vol. ratio. To put another way, their realized volatility is a lot lower than what the options prices indicate. This translates into a standard deviation of 9.6% versus 12.50% for the S&P-500. Their correlation with the US Market is 0.83, but by selling delta-neutral strangles we take that number to a whole different level: 0.15 or less.
You can also combine the SPLV tracker (low-volatility index fund) with covered call writing on the SPY tracker. You can implement this strategy easily and get a much more attractive risk/reward ratio. I've already written an in-depth article on this approach. You can re-read it HERE.
The drawdowns are considerably lower which is just amazing considering the sell-off of Q4 2018. Fewer drawdowns mean that our put strikes are tested less frequently.
Additionally, this is a crucial aspect for premium sellers as puts are often priced with elevated implied volatility and thus more expensive than the calls. If you can minimize the impact of drawdowns, you should capture much more of the put premium relative to the call premium. So, looking for low-beta stocks with noticeable put skew bears fruit in the long run. This has proven to be a very successful strategy over the past years as you generated higher profits with less volatility. The downside to this approach? You have less occurrences if you wait for these events. Below you find the screenshot of NEE and its corresponding IVs for puts and calls. The wider the spread, the richer the put premia relative to calls and it’s just another factor in creating optimal conditions for our option selling portfolio. This is interesting as you have the same deltas for puts and calls (10-delta strangles for example), but you benefit more from an uptrend than a downturn, which has been the case for low-beta stocks for good part of the past 20 years.
Selling Premium In Low And High IVR: Low-Delta And High-Delta Strangles
There’s very little doubt about the benefits from selling premium when implied volatility is at the upper end of its range. However, when implied volatility is low should we still stick to premium selling strategies? As one can see from the graph below, you’ll notice that the profit and loss is substantially higher if we sell premium when IVR is above 50% or when the VIX is above 25. If implied volatility is low, we don’t get enough bank for our buck when opting for high-delta strangles. What sticks out, though, is the difference between selling premium in low versus high IV which less pronounced if utilize 10-delta strangles. This is why we prefer selling premium in low IVR by leveraging 10-delta strangles instead of taking on too much risk by looking for higher delta strangles that offer more premium. If IVR is above-average, we’ll take advantage of the 15-delta strangle to improve our Return On Capital (the relationship between risk and reward is much more optimal). One could say that in low IVR, you set a minimum of daily theta (positive time value) you’d like to collect and scale up in higher IVR. Our win rates also improve if one chooses higher-delta strangles when IVR is high, relatively speaking of course. As always, being mechnical is what makes short strangle selling work.
Relationship Between Actual Probability Of Profit And Non-Correlated Diversification
When determining position sizing, it is crucial to analyze our probability of profit and correlation of underlyings to current positions. We typically see a tradeoff between POP and max profit potential; higher POP trades should be allotted a larger portion of your portfolio relative to low POP trades. We find the greater the POP, the smaller chance of us having multiple losses. Interestingly, we benefit from diversification, and thus trading underlyings with little correlation to each other. Otherwise, it’s essentially the same trade. By applying delta-neutral strategies on non-correlated low-volatility assets (healthcare, information technology, utilities, real estate, consumer goods), we reduce our correlation even further while maintaining the same average P/L with less standard deviation. The lower our standard deviation, the better we can manage our portfolio and the better we can set realistic goals.