Preparing For The Next Correction When Selling Short Strangles

Nov. 21, 2019 11:56 AM ET14 Comments
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Option Generator
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Summary

  • In the world of selling options, we want to minimize daily portfolio volatility and keep our directional exposure as low as possible.
  • That's especially true when you already have a buy and hold portfolio which can deviate heavily from the broader market.
  • 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.

Preparing For A Correction

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. Their value, however, can deviate heavily from the broader market and there's no guarantee of sustainable investment success.

Option selling is, therefore, a non-directional play, in my humble 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.

(Source: Lohman Econometrics)

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 (SPY) 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

This article was written by

Option Generator profile picture
3.78K Followers
Long-term buy and hold investor, looking for high-quality long-term compounding machines and embracing the GARP rationale. Stringent focus on return on capital, cumulative growth of reinvested cash flows and prudent financial management, i.e., manageable/low leverage.

Disclosure: I am/we are short 105/115 STRANGLE ATO JANUARY, 220/280 JANUARY STRANGLE LII, 90/105 STRANGLE JANUARY YUM AND OTHER SHORT STRANGLES IN OUR PORTFOLIO SHARED WITH PREMIUM MEMBERS OF OPTION GENERATOR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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