Updated: Nov 19, 2019
In the world of selling options, we want to minimize daily portfolio volatility and reduce our directional exposure. That's especially true when you already have a buy and hold portfolio which consists of long-term investment opportunities you want to own for a very long time, regardless of market sentiment. Option selling is therefore a non-directional play in my opinion and I want to use it solely for portfolio volatility reduction while collecting time value. But when markets are at all-time highs and investors get extremely greedy (like the world we live in right now with no significant improvement in EPS estimates), even selling delta-neutral option strategies can turn into directional plays when volatility shoots up. Volatility is now very low across the board, markets have posted a stellar performance so far in Q4 and last week, here at Option Generator we started to skew our strangles with short delta to mitigate the impact of a sudden selloff.
It's always appropriate to stick to a contrarian view instead of chasing the market. It's far more interesting to remain non-emotional and add some short delta (while generating positive daily theta) when markets are euphoric instead of shorting the bottom. Adding short delta is also relative, which means that if the S&P-500 goes up by 1%, you don't want to lose that same 1% in one day. I'd rather want to be short 0.5-1 my daily theta number in this market. That means that if the market goes up by 1% and you collect 0.15% in daily theta, you lose 0.075%-0.15% because of short delta. However, when markets rally, volatility oftentimes decreases meaning you benefit from a contraction in an option's implied volatility. So adding short delta to an options portfolio doesn't have to be aggressive or way too directional or speculative, it's just a way of creating a natural hedge for our short strangles while collecting sufficient premium and leaving room to the upside.
And while our short deltas have weighed on our recent returns, we still generated a very nice time value return, though, lagging the broader market is always painful. At least in the short term, as most people - especially these days - focus on return rather than risk-adjusted returns. I'd rather prefer the adage: winning by not losing via selling strangles on low-volatility stocks and collecting a steady daily cash flow.
Stated differently, controlling your positions, keeping your size under control so that you can make individual adjustments along the way and selecting low-volatility stocks as short premium underlyings is what everyone should do. The next telling chart gives you insight into why we are considering adding LII, YUM and ATO to the short strangle portfolio.
When the market corrects, these stocks tend to show decreasingly positive or increasingly negative correlation meaning they should be seen as somewhat safer than other stocks and the broader market in general. That's because of their predictable cash flows and less cyclical nature. As you can see from the chart, these boring low-volatility stocks currently lag the market, underpinning euphoric sentiment. When markets finally sell off, they tend to fall a lot less which is great for a short strangle strategy: the rallies are not that pronounced; neither are the drawdowns. Also, implied volatility is overstated the most in low-volatility stocks. Let me give you a quick example by referring to ATO. That stock has enjoyed an actual volatility of 8% over the past two years, whilst its implied volatility hovers around 15+%. You get more premium and less down or upticks and therefore its a wonderful stock to use in a conservative short strangle portfolio.
Reducing drawdowns particularly makes sense for those of you who want to reap the fruits from the wonderful compound interest effect.
However, a serious decline makes it very tough to succeed in achieving your financial goals. In today's market environment with low interest rates and pricey valuations, future returns aren't going to be 10+% but rather 4%-6% in best case and that's why low-volatility stocks are very useful in producing far higher risk-adjusted returns. Simply buying an index fund doesn't provide you with the best risk-adjusted returns, consider smart option selling on low-volatility stocks instead. Even if you're not familiar with short strangles, you can try iron condors or just sell covered calls to reduce your directional exposure and control your outcome.