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Maximize Returns With Option Overlays


Investors in 2018 are faced with a challenging investing environment for both US stocks and bonds. So what can an investor do to increase portfolio returns without taking on too much additional risk? Those comfortable with and capable of trading simple option income strategies like strangles may be able to accomplish this objective.  

A popular option strategy is the short strangle, which consists of selling an out of the money put and call. My personal backtesting and real trading experience is that this strategy on equity market ETF's or cash settled indices can increase portfolio diversification and if overlaid on a portfolio of underlying assets like mutual funds or ETF's can also increase total returns. 

 

When you sell a strangle, you bring cash into your account. By doing so, you can "overlay" this trade on top of a portfolio consisting of ETF's or other investments without paying margin interest. Before we get too deep into the weeds, lets deal with the elephant in the room...you've heard strangles are risky. Is that true? The answer isn't that simple, as the trade isn't what measures risk, instead, it's the position size. Excessive leverage is risky, but strangles don't have to be traded this way. I'd encourage every option trader to not only consider the margin requirement of any particular option trade, but the notional risk. For example, think in terms of a 1 contract SPY strangle with SPY trading at $280 as theoretically being a $28,000 position (stock price X 100), similar to how buying 100 shares of SPY at $280 is a $28,000 position. When sized this way, a typical strangle will actual have less risk than the underlying asset.

 

With this in mind, let's look at a rough example of how we could implement this idea in a $100,000 account. First, we'll look at the performance of a 50/50 stock/bond portfolio that is rebalanced monthly since 2000.

 

1.png

 

This portfolio would have returned a little over 5% annually, with a standard deviation of 7.31%, producing a Sharpe Ratio of 0.54. 

 

Next, we'll add a 50% strangle allocation to this same portfolio. Yes, this equals 150%, which does make this concept only possible in a taxable margin account. The strangle allocation is based on our own backtesting platforms and proprietary rule sets and includes hypothetical trades on both SPY and IWM. A trader would sell 2 strangles on SPY in a $100,000 account to approximately replicate the concept. 

 

Blue: Stock/Bond Portfolio

Red: Stock/Bond/Strangle Portfolio

 

 2.png

 

The 50/50/50 portfolio nearly doubles the annualized return to over 10%, and only with a modest increase in standard deviation to 8.37%. This increase in risk adjusted return substantially improves the portfolio Sharpe Ratio to 1.05. Even with a 50% increase in total portfolio allocation, the portfolio risk only slightly increases due to the low correlation of the strangle strategy to both stocks and bonds. This example is only meant to show the concept of an option overlay in action, and the potential benefits of doing so. Many other creative ideas could be implemented with other underlying assets and option strategies. My investment advisory firm, Lorintine Capital, currently implements these concepts in managed accounts as well as in one of our private funds, LC Diversified Fund. We are happy to have discussions with investors interested in a professionally managed solution, or ideas on how to implement this concept on their own.  

 

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™. 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 is managing the LC Diversified portfolio and forum, the LC Diversified Fund, as well as contributes to the Steady Condors newsletter. 

Edited by Jesse

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Thank you Jesse for a very interesting perspective of selling strangles.

As many of you know I'm not a big fan of selling naked strangles. However, as Jesse mentioned to me, people think they are ‘risky’ b/c of horror stories like Karen the ST…but it’s not about the trade that made what she did risky, it was excessive leverage.

The bottom line is that a short strangle by itself is not necessarily "risky" if it's done with responsible position sizing. 

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I agree 100% - "risk" is not defined strictly by the type of position, but by proximity between strikes and resistance/support, moneyness of option to current price, volatility level, and number of positions opened. One of the great problems in the industry is a perception that risk is identified simply by the title of the trade. It is more complex.

 

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Guest Sam

Posted

Interesting article Jesse - would be a lot stronger / more substantial with a) guidance on what deltas to sell and b) what deltas were sold in the back testing of the strategy from 2000 (assuming a consistent strategy was applied).

Do those backtested returns imply being short the strangle through expiration? 

What's the plan for managing it if under pressure?

Thanks, Sam

 

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