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Bullish Short Strangles


A bullish short strangle sounds like a complicated strategy, but it’s really quite simple for those familiar with option terminology. A short put is combined with a short call to where the position starts with some amount of positive delta overall. This distinguishes itself from a delta neutral strangle, where both the short put and short call are sold at the same delta.

My investment philosophy is built upon harvesting risk premiums with positive expected returns. Examples of risk premiums that meet my personal criteria for inclusion in a portfolio include the equity, size, value, and volatility risk premiums. The volatility premium is the persistent tendency in the options markets for implied volatility to exceed realized volatility. This should not be perceived as market mispricing, but instead, rational compensation for risk to the seller of option contracts.This is similar to how insurance companies are profitable over the long term by collecting more in premiums than paying out in claims and other expenses. Buyers of insurance are willing to lose a relatively small amount of money in the form of recurring premiums in order to transfer the risk of a large loss. Sellers of insurance need a profit incentive in order to take on this risk.

 

A bullish strangle is a way to gain some exposure to the equity premium with reduced downside risk. Every option strategy includes tradeoffs, and the bullish strangle tradeoff is less upside capture in a rising market…and even potential losses. I’ve used the ORATS Wheel to complete backtests from 2007-current on 3 different equity index ETF’s…SPY, IWM, and EFA. The trading parameters used were:

 

  • DTE: 30
  • Short Put Delta: 40
  • Short Call Delta: 16
  • Exit: 80% of credit received, or 5 DTE, whichever occurs first
  • Collateral yield: None

 

Results:

 

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This is impressive considering that no collateral yield is included. For example, US Treasury Bills are conventionally used as a risk-free form of collateral for option selling, and would have added just under 1% per year to the total returns during this period. Adding some term risk to the equation with 5 Year Treasuries, similar to what we do in Steady Momentum, would have added almost 4% per year during this period along with diversification benefits that would have increased the overall Sharpe Ratio.

 

Conclusion

 

Options are a great addition to a portfolio for the disciplined and well-informed trader/investor. They don’t have to be used as a speculative tool, nor do they have to be used in a high-risk manner. The bullish strangle is potentially a great strategy for an investor with a more guarded outlook on the equity markets or who simply lacks the courage to buy traditional index funds.

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.

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Jesse, am I understanding this correctly? You have naked short puts and calls? Are you assuming to buy/short SPYs if the puts/calls get assigned? How about tail risks? Seems like a very risky strategy.

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Naked strangles got a bad reputation due to excessive leverage. Fund managers like Karen Supertrader was selling naked strangles using portfolio margin and probably 4-5x leverage. This is a certain path to financial ruin.

With no leverage, naked strangles are no more risky than just holding the stock. If the stock goes down by $100, the naked put will actually lose less because of the premium you got. So if you sell number of puts equal to number of shares you would buy with no leverage, the tail risk is no higher than just buying the stock (in fact, less). Plus you get the premium from the sale of the calls (which obviously adds upside risk).

 

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I tried to do a backtest SPY based on the information above. When I use Trademachine to backtest I get negative return or zero return for all periods (6 month to 5 year). At 10 year I get total 87% return. No matter the time period, owning SPY outperformed the strangle strategy, except if the crash period in 2008 is included (which is interesting)

At what time was the strangle entered (beginning or end of day)? (Trademachine uses end of day)

Is there another exit (if loss?) not shown above that could alter these back-test results?

Is your backtest consistent with mine (= loss for shorter periods)

Edited by JacobH

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Be careful with the way ORATs calculates returns based on a % of the underlying.  I always felt the results were wonky and had to put them into my own spreadsheet to get a better feel or risk/return.

 

A bullish, positive delta strategy no doubt worked very well the past 12 years.  Would you really use something like this going forward?

 

 

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