Structuring A Short Strangle Portfolio: Why IVR, Portfolio Sizing And Research Make Total Sense

Updated: Dec 14, 2019


Why should we tend to look for high IV ranks rather than chasing absolute IV numbers and getting burned if the price of the underlying starts crashing or rallying or just because of a spike in volatility hurting your margin requirements? Sticking to sound portfolio sizing (how much margin do you need to set aside?) and maintaining a rigorous approach that makes mathematical sense (for instance selling short strangles with deltas of 1 combine a high win ratio and attractive risk/reward) will benefit your portfolio the most.

Within two to three weeks, I'm going to launch a new concept titled the Short Strangle Champion which covers the journey of an older couple towards generating 1.5% each month via low delta (5-10) short strangles. They were blessed to retire at 45, but want to generate more income beyond saving, bonds but want to reduce their market exposure. I'm appointed as asset manager and came up with the idea of selling ultra-conservative strangles. You will be able to track our investment philosophy, progress made and portfolio metrics on my profile on Seeking Alpha.

1) Implied volatility

Let's get right into it: implied volatility metrics; raw data about an underlying's IV, do they provide you with a substantial edge? Take a look at the following graph for Alibaba.

Changes in volatility have a major impact on short-term and long-term options. The stock market is unpredictable and so is implied volatility. Finding an equilibrium between controlling margin requirements and projecting a realistic monthly premium income is what makes option selling so fascinating.

You hopefully notice huge swings in implied volatility. The average IV YoY is 38%. In an ideal world, we want to sell premium when IV is higher than 38% and thus has an IV rank of at least 50%. Since we're selling strangles, why does that make total sense? First, the width of our strangles depends on the implied volatility and in order to put some context our that number and compare apples to apples, we should have a clear understanding about how expensive options are. Shorting strangles when the IVR is subdued will lead to less room on the put and call side. To put another way, your profit range is narrower compared to selling premium in high IVR environments. Also, the higher volatility, the higher the premium and the higher our positive theta will be. Additionally, higher-than-average IVR tend to decrease throughout the life cycle of the trade except for upcoming earnings report which induce elevated implied volatility. As Alibaba shows swings in implied volatility, we have less occurrences to benefit from.

If we sell premium in low IV environments, we're at risk of taking on too much uncertainty in our P/L because:

  • A spike in IV results in huge fluctuations in our margin requirements, make sure you clean up your portfolio allocation from time to time and adjust directional risk

  • The lower IV rank, the narrower our range is going to be and thus when volatility picks up, deltas increase and it's a lot tougher to exit our position because the underlying starts moving more intensively

  • If volatility increases, so will the deltas associated with the strikes you sold making expiration a binary event. In order to circumvent that, we'll have to roll out the trade 10-15 days before expiration.

What are the benefits from rolling a position out in time when there's a pop in volatility and you're short strangles that increase in value each day? That's exactly what happened to nearly every security during the December 2018 drop. Indices skidded 10% in a very short period of time and growth stocks got slaughtered by 30% in one single quarter. There isn't much you can do, right?

If you trade stocks that have a relatively constant IV but move a lot less in reality, these trades will give you more margin control. An example would be SBAC Communications whereby I circled the occurrences with IV rank above 50 in red. In this case, it's hard to believe that IV can spike 15% or more in a very short period a time. Trading more aggressive stocks can result in an IV pop of 35 to over 50%!

Does it make much sense to sell premium when IVR is high? Research from the past up until now draws the same conclusions from varying IVRs: the higher the IV rank, the higher your profits and win rates are going to be. In Apple, 63% of the time (from 2011-2017), you harvested the most appetizing premium when IV rank was edging above the 25% barrier.

The numbers speak for themselves, right?

And when the IVR gets closer to 50% and you kept enough buying power on the sidelines (at least 55% of your capital is optimal). Selling options on stocks with high and stable IVR make portfolio management a lot more efficient.

Is there action you should take when IVR is below? Selling three-month options can provide us with substantially higher profits, less gamma risk and less volatility in daily P/L. Referring to a great piece from Tasty Trade, they conducted the following study;

Utilizing different time periods smooths out our overall portfolio volatility and is highly valuable in times of low IV.

2) Rolling Positions Out In Time: Restructure Your Portfolio Automatically

Rolling out in time is one of the redeeming qualities about having a trade turning against you as it gives our short strangle trades more time to work out favorably. With longer term options having a higher Vega and the IV rank increasing, the odds of a shrinking IV are elevated the following weeks except for earnings releases. More about this topic in the next paragraph.

I've already addressed this topic in one of my articles, but here you have a very powerful table containing concise information why rolling out in time works to mitigate losses, increase your win rate and achieve a higher daily P/L.

The concept behind selling strangles explained in this article definitely serves as a source of crucial information.

3) Rolling Your Strikes Throughout The Cycle

One of the dilemmas we have to deal with is rolling up puts or rolling down calls when one of our strikes gets breached. The main advantage of selling strangles is the ability to recenter your deltas after you entered the delta-neutral trade. Rolling way too early results in a narrower profit range and that's one of the mistakes I've made more than once until you acknowledge why it doesn't make sense. Granted, it's far more subjective than a rule. The primary reason we re-center our deltas if and when our strike gets breached is to avoid we take action way too early and thus unwillingly cap our win ratio and profit area. Again, luckily, Tasty Trade made a bunch of research about tackling this issue such as the piece from 2013-May 2015.

Initially, one sold a 16 delta strangle which has a theoretical success rate of 72% (100 minus two times 16 on each side of the trade). However, in actuality, that win rate approximates the 82% because the expected moves are a lot smaller than indicated by options prices.

Rolling does increase our win ratio if we stick to 30 deltas and puts more credit into our pockets. Sounds great for our wallet but we have to maintain a mechanical approach in order to let the probabilities work out in our favor. It also depends on the timing of these rolling transactions. Does it make sense to execute these trades when gamma risk is increasing? Probably not. Almost nobody, including me a while ago, is worried about rapidly changing gammas. With 15 days before expiration, instead of rolling down calls or rolling up puts, you'd better just re-establish your position and sell your initial deltas of 10-15.

4) My Own Approach To Selling Options

After having experimented with several option strategies and learned the consequences of being greedy the hard way, I've now created a rigorous trading plan consisting of the following cornerstones:

  • Selling 10 delta strangles with about 50-45 DTE

  • Favor IV of more than 20%, maximum 40%

  • Selling strangles on stocks with IVR above 50% if possible

  • If one of the strikes gets breached, roll the untested side to a delta of 30 when the gamma risk is manageable (gamma should be lower than our daily theta)

  • Roll out in time when 21 DTE

  • Collect initial daily theta of at least 0.14% and maximum 0.16% on our net liquidity (in order to meet our monthly option income goal). We don't close out trades when this number edges above 0.16%.

  • If volatility implodes causing our theta to the decrease, close out the position with the lowest IVR and look for trades with an IVR of >50 with 50-45 DTE

This list of criteria will help us determine what our portfolio needs to generate sustainably growing income. Not getting greedy (looking at portfolio sizing and theta) , focusing on IVR and rolling out in time in order to circumvent the devastating impact from gamma risk are the most important takeaways and are all backed by ample research items. It's an active approach that you have to feel comfortable with in order for it to work.

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