Building a Short Strangles Portfolio

@Stephan HallerThank you for another great article!

I like the idea of non correlated instruments. In this case, my biggest concern probably is regarding IWM and TLT. Since they have a pretty strong inverse correlation, wouldn't a strong down move in IWM cause a strong up move in TLT, causing both strangles to be losers?

Also, what are your live results trading this portfolio? For how long have you been trading it?

@Kim Of course, there are times when IWM makes a big down move and TLT makes a big move in the other direction.
We have seen this lately, but you can get it under control by adding a short delta/short premium position in SPY, IWM, or QQQ when vol pops.

IWM's correlation to SPY is 0.63 and TLT's correlation to SPY is -0.32.
So long term they aren't this much negatively correlated.

The easiest underlying to trade for short straddles is FXE, but you also get paid the least premium.
I have been trading a short straddle/30 delta short strangle portfolio for almost 5 years now.
But I have always made some adjustments to the strategy (like switching from a static profit target like 50% of max. to a dynamic profit target like 16 delta strangle credit).
In very low IV I add classic put diagonals in SPY or put calendar spreads in SPX and I also cut down my size.
When IVR goes above 50% I ramp up my trade size and I also add short delta/short premium positions like aggressive short delta strangles or call ratio spreads in SPY, QQQ, or IWM to hedge my vega risk and balance my deltas.
I also mechanically roll the untested side when one of my short strikes, or in case of straddles, my break even gets hit.
When we hit 21 DTE I usually close and reestablish delta neutral or a little bit directional if it fits my overall deltas.

Except for 2016, when I went crazy and shorted the Trump rally way too big, I averaged about 15-16%.

As long as I stick to the rules, it works.
But a big ego and thinking that you know something always ends bad.
I'm still learning and I hope, it never ends.
You need to look at every losing trade to become a better trader.

So basically without leverage you would get around 6-7%, which is in line to my previous estimates here and here.

The big question is how much volatility you add by increasing the leverage, and what would be the drawdown with leverage during periods like 2008 and 2011?

@Kim Great question!

Here is the answer:

https://steemit.com/steemleo/@stehaller/the-worst-that-can-happen-to-a-short-straddle-portfolio

Thank you @Stephan Haller

I'm not sure this is "the worst that can happen", as in Sep.2008 IV was already very high, and you got healthy credits for all straddles. However, don't forget that 20% is a one month loss. We don't know how previous and next trade performed, so we don't know what was the total drawdown.

But I agree that the loss is very manageable. And we are in a full agreement that as long as you don't over leverage, the risk is reasonable.

The problem is that with naked straddles/strangles, it's very easy to over leverage, especially if you have portfolio margin. In fact, I think very few people would base their position sizing on notional value instead of margin.

@Kim In most underlyings in the portfolio the P&L the month before was great, since markets didn't move much.
The next months would have been pretty good either, since vol was extremely overstated.

In a regular margin account it is hard to over leverage on short strangles/straddles.
Most people I know (including myself) over leveraged in credit spreads and/or iron condors.

Portfolio margin is dangerous for most people.
I always advise people who have portfolio margin to check out the CBOE regular margin calculator to see what regular margin would be and then size their positions like in a regular margin account.

Portfolio margin is great when you need the extra buying power in an overnight move.
Let's assume you had lots of short calls on before the 2016 election night and not much buying power left.
With portfolio margin you could have bought the right amount of /ES and lock in your profits.

Agree regarding portfolio margin.

Personally I still wouldn't be comfortable with 3x leverage in notional value, but that's just me. I also would never be comfortable holding a portfolio of only gamma negative strategies. You never know when the next flash crash will come. Again, matter of personal choice.

Don't forget that those backtests are based on mid prices. During periods like 2008, there is no chance to get filled anywhere close to mid prices. I believe if you applied 3x leverage in 2008, a 50-60% drawdown was almost guaranteed.

Hi
Thanks for a great discussion. I've been looking for this type of study for year :))

Is trading FXE even worth it to you?  Whenever I looked at it, strangles seem to pay less than a 0.9$ on a 110$ underlying.... (about 100$ max profit for 3000$ margin requirement)
Have you tried other low correlated assets like UNG,XLU?