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Building a Short Strangles Portfolio


In my last article I showed you what you can expect selling short strangles and straddles and how much leverage is appropriate. Today I want to show you how to build a well diversified short strangle/straddle portfolio and how to trade it through difficult times.

Lately we experienced a 7% down move in the S&P 500.
 

01. SPY Chart.png

image source: TOS trading platform

 

We have also seen an explosion in the VIX.

VIX Chart.png

image source: TOS trading platform

 

All in all a pretty shitty situation if you have a delta neutral short premium portfolio.
 

So let's have a look how a portfolio consisting of 30 delta short strangles and/or atm short straddles in IWM, FXE, TLT, GLD, XLE, which was started before this wild ride in the markets happened, would have performed.
 

Set up

As shown in my booksIWM, FXE, TLT, GLD, XLE are the most uncorrelated ETFs. With these underlyings you have exposure to the Russell 2000, the Euro Currency, Bonds, Gold and the Oil Sector.
 

Rules

  • $100k portfolio
  • capital allocation based on the VIX (20-25% allocation in very low VIX environment, 40-50% in a high VIX environment)
  • equal buying power in all underlyings
  • never go above 3x leverage in notional value
  • 30 delta short strangles or atm straddles
  • about 45 DTE
  • profit target = 16 delta strangle credit at trade entry
  • close all positions at 21 DTE if profit target is not hit before
  • if short strike in strangles gets hit, roll untested side into a short straddle (original profit target doesn't change)
  • if break even in a short straddle gets hit, roll untested side to the new atm strike (going inverted)
  • if IVR in IWM goes above 50% and/or VIX makes a big up move, add aggressive short delta strangle to balance deltas
     

Portfolio Performance

As a starting date I picked July 30th 2019, probably the worst day in this expiration cycle to start this kind of portfolio. Since the VIX and IVR was pretty low at this moment, I committed only a little bit above 25% of my net liq.
 

IWM

02. IWM Chart.png

image source: TOS trading platform
 

FXE

03. FXE Chart.png

image source: TOS trading platform

 

TLT

04. TLT Chart.png

image source: TOS trading platform

 

GLD

05. GLD Chart.png

image source: TOS trading platform

 

XLE

06. XLE Chart.png

image source: TOS trading platform

 

Portfolio

Portfolio.png


So far in dollar terms a $1,571.50 loss or 1.571% loss on the whole portfolio.

Not too bad considering the IV explosion and the big moves, especially in TLT.

As you can see, even in a tough market with big outside the expected moves and IV explosion, short strangles/straddles are not a recipe for disaster.

The key is to trade small when IV is low and mechanically adjust your positions/deltas.

Of course the expiration cycle is not over yet and we can still have more big moves and much higher implied volatility in the coming days, but you should have seen now, when you have the right set of rules and religiously stick to these rules and when you trade small enough when IV is low, you are not going to blow up your portfolio.

Stephan Haller is an author, teacher, options trader and public speaker with over 20 years of experience in the financial markets. Check out his trilogy on options trading here. This article is used here with permission and originally appeared here.

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@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?

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@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.

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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?

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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.

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@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.

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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.

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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? 

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