SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Selling Naked Strangles: The Math


Selling short (naked) strangles is heavily promoted by some options "gurus". Is it a good strategy? It might have an unlimited (theoretical) risk, but what about the return? Is the return worth the risk? We decided to do some math, based on real prices, not some theoretical "studies".

Assumptions:

  1. $100,000 account.
  2. Sell SPY 10 delta calls and 10 delta puts.
  3. Use options expiring in 30 days.
  4. Base the number of contracts on "notional exposure", not margin. 
  5. Hold till expiration, then open the next trade.

Notional value speaks to how much total value a security theoretically controls. For example, with SPY around $290, that means selling 1 SPY strangle per ~$29,000 of capital.
 

With SPY around $288 on August 12, 2019, we will be selling the following strangle:

  • Sell 4 Sep.11 2019 264 put
  • Sell 4 Sep.11 2019 302 call

Those strikes are the closest to 10 delta. 4 contracts give us notional exposure of $115,200 ($288*100*4), which means 1.15 leverage. This is fairly conservative exposure.


This is how the P/L chart looks like:

image.png

Please note that our total credit is $676 (assuming we can get filled at the midpoint).

Now lets do the math. 

If ALL trades expire worthless and we keep all credits, we will collect $676*12=$8,112. This is 8.1% on $100,000 account. But this is the best case scenario. This is probably not going to happen. Based on the deltas of the options, this trade has around 80% probability of winning. Which means that statistically, 2-3 trades per year will be losers.

Now, lets be conservative and assume that 2 trades per year will be losers, and the losing trades will lose the same amount as winners ($676 per trade). In reality, when the markets move against you, even with the best risk management, your losers are usually larger than your winners when you trade a high probability strategy. But again lets be conservative.

Note: The theoretical probability of winning is based on deltas and implied volatility, while the actual win rate is slightly higher because of the volatility risk premium (IV exceeding RV over time). But it doesn't have material impact on the results.

This assumption gives us total P/L of $676*10-$676*2=$5,408. That's total annual return of 5.4%. You can use T-bills as a collateral, which might add 2-4% to the annual return.

In no way this single example can represent the whole strategy, and this calculation might not be very "scientific". Different dates or parameters might provide slightly different results, but this is a ballpark number. We estimate the range to be around 5-7% per annum.

Of course fund managers like Karen Supertrader who use similar strategies realize that those returns probably would not attract too many investors, and also would not get her a spot in tastytrade show. What's their solution to get to the 25-30% annual return they advertise? The answer is: leverage. To get from 5% return to 25%, you need 5x leverage, or 20 contracts.

To see how the leveraged trade would perform during market meltdown, lets assume it was initiated on Dec.3, 2018, with SPY at 280. Three weeks later, SPY was around 234, 16% down. This is how the trade would look like:

image.png

That's right, the $100k portfolio would be down 50%. This is how you blow up your account.

In this case, the 16% market decline took 3 weeks. What if it was 25% decline happening in one week? You can only imagine the results.

Of course we could change the parameters, use 20 delta options, different time to expiration etc. This would not change the results dramatically. With 20 delta options, you would get more credit, but also higher number of losers per year.

Does it mean the selling naked strangles is a bad strategy? Not necessarily. In fact, according to CBOE Volatility Risk Premium and Financial Distress, 1x notional strangle on SPX has historically returned about the same as SPX with 3x the Sharpe Ratio:

image.png

But the strangle itself produced around 6% annualized return, which is pretty close to the performance we calculated. Rest of the return came from the collateral.

The bottom line is: selling naked strangles on indexes is a good strategy if used with a sensible amount of leverage. But you should set your expectations correctly. I suspect that most traders would probably base their position sizing on margin, not notional exposure, which is like driving a Ferrari 190 MPH down a busy street...just because you can. This would increase the return, but also the risk. If you base your position sizing on notional exposure, the risk is pretty low, but so is the potential return. 

Naked options by themselves are not necessarily a bad thing. The problem is leverage and position sizing. If implemented correctly, naked options can make money in the long term. But if you overleverage, you just cannot recover from the inevitable big losses. We warned our readers about the dangers of naked options and leverage on several occasions. It's not the strategy that killed Karen Supertrader, James Cordier, Victor Niederhoffer and others. It's the leverage and lack of risk management.

What about selling naked strangles on individual stocks? Personally, I would never do it, especially not before earnings. The risk is just too high. But lets leave something for the next article..

“The problem with experts is that they do not know what they do not know.” 
― Nassim Nicholas Taleb.

Related article:

Edited by Kim

What Is SteadyOptions?

12 Years CAGR of 122.7%

Full Trading Plan

Complete Portfolio Approach

Real-time trade sharing: entry, exit, and adjustments

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Subscribe to SteadyOptions now and experience the full power of options trading!
Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • SPX Options vs. SPY Options: Which Should I Trade?

    Trading options on the S&P 500 is a popular way to make money on the index. There are several ways traders use this index, but two of the most popular are to trade options on SPX or SPY. One key difference between the two is that SPX options are based on the index, while SPY options are based on an exchange-traded fund (ETF) that tracks the index.

    By Mark Wolfinger,

    • 0 comments
    • 755 views
  • Yes, We Are Playing Not to Lose!

    There are many trading quotes from different traders/investors, but this one is one of my favorites: “In trading/investing it's not about how much you make, but how much you don't lose" - Bernard Baruch. At SteadyOptions, this has been one of our major goals in the last 12 years.

    By Kim,

    • 0 comments
    • 1,192 views
  • The Impact of Implied Volatility (IV) on Popular Options Trades

    You’ll often read that a given option trade is either vega positive (meaning that IV rising will help it and IV falling will hurt it) or vega negative (meaning IV falling will help and IV rising will hurt).   However, in fact many popular options spreads can be either vega positive or vega negative depending where where the stock price is relative to the spread strikes.  

    By Yowster,

    • 0 comments
    • 1,259 views
  • Please Follow Me Inside The Insiders

    The greatest joy in investing in options is when you are right on direction. It’s really hard to beat any return that is based on a correct options bet on the direction of a stock, which is why we spend much of our time poring over charts, historical analysis, Elliot waves, RSI and what not.

    By TrustyJules,

    • 0 comments
    • 716 views
  • Trading Earnings With Ratio Spread

    A 1x2 ratio spread with call options is created by selling one lower-strike call and buying two higher-strike calls. This strategy can be established for either a net credit or for a net debit, depending on the time to expiration, the percentage distance between the strike prices and the level of volatility.

    By TrustyJules,

    • 0 comments
    • 1,725 views
  • SteadyOptions 2023 - Year In Review

    2023 marks our 12th year as a public trading service. We closed 192 winners out of 282 trades (68.1% winning ratio). Our model portfolio produced 112.2% compounded gain on the whole account based on 10% allocation per trade. We had only one losing month and one essentially breakeven in 2023. 

    By Kim,

    • 0 comments
    • 6,205 views
  • Call And Put Backspreads Options Strategies

    A backspread is very bullish or very bearish strategy used to trade direction; ie a trader is betting that a stock will move quickly in one direction. Call Backspreads are used for trading up moves; put backspreads for down moves.

    By Chris Young,

    • 0 comments
    • 9,766 views
  • Long Put Option Strategy

    A long put option strategy is the purchase of a put option in the expectation of the underlying stock falling. It is Delta negative, Vega positive and Theta negative strategy. A long put is a single-leg, risk-defined, bearish options strategy. Buying a put option is a levered alternative to selling shares of stock short.

    By Chris Young,

    • 0 comments
    • 11,402 views
  • Long Call Option Strategy

    A long call option strategy is the purchase of a call option in the expectation of the underlying stock rising. It is Delta positive, Vega positive and Theta negative strategy. A long call is a single-leg, risk-defined, bullish options strategy. Buying a call option is a levered alternative to buying shares of stock.

    By Chris Young,

    • 0 comments
    • 11,821 views
  • What Is Delta Hedging?

    Delta hedging is an investing strategy that combines the purchase or sale of an option as well as an offsetting transaction in the underlying asset to reduce the risk of a directional move in the price of the option. When a position is delta-neutral, it will not rise or fall in value when the value of the underlying asset stays within certain bounds. 

    By Kim,

    • 0 comments
    • 9,894 views

  Report Article

We want to hear from you!


VERY good article. I know some traders are really feeling some pain out there right now. Conservative position sizing is one sure way to give yourself a little edge and confidence to be able to do this long term. 

Share this comment


Link to comment
Share on other sites

You are right that leverage is a solution but not in the way you think:

- own capital (i.e. from investors) 10,000$ ;

- borrow the equivalent of 90,000$ in the Eurozone at monthly rates of say 0.2% over EURIBOR - that would be -0.2%;

- perform a swap transaction of the currency into US$ which includes eliminating the currency risk - this will have a variable cost but lets put that at 1% - it can be more or less.

Now lets take your assumption that they can make 5% on a 100K. That would now look like this:

  •  +5,000$ income from the SPY strategy
  • - 720$ Total cost of swap/interest
  • +4,280$ profit for investors

That is a 42.80% return on an annual basis. You could be less sophisticated and just borrow monthly US$ which costs around 2.5% tops - the strategy remains the same and the return would be 25% annualised. There is still huge risk involved in this transaction even though its mitigated somewhat by the fact you trade monthly SPY. There can be a refinancing problem or interest rates could rise which would eat into your return like there is no tomorrow.

Obviously this isnt happening wholesale and so the premise of your article that you wont lose more than you win on your two losers is at fault here. Whilst you can mitigate the losers somewhat taking them at least at the triple value of a 'regular' win is already more realistic. You then have a 3% or less return which means that unless you go the sophisticated way of foreign currency swaps and the whole shebang you will find it hard to get to where you need to be.

If there was a strategy yielding standard 5% (without additional risk) today all the big money in the market would be into it. Big fortunes fear above all to make big losses and do very well on modest growth.

 

Share this comment


Link to comment
Share on other sites

Totally agree about the "gurus" pitching option selling as some great alternative to buy and hold without really addressing the risks (including the risk of under-performing buy and hold which is likely the case over the past 10 years).

On the positive side,  my father who is in retirement mode may be fine with a 5% annualized return that has less volatility that holding SPY and provides a diversified income stream.   I think it just depends on your goals and tolerances for risk.

 

 

Share this comment


Link to comment
Share on other sites
19 hours ago, TrustyJules said:

You are right that leverage is a solution but not in the way you think:

- own capital (i.e. from investors) 10,000$ ;

- borrow the equivalent of 90,000$ in the Eurozone at monthly rates of say 0.2% over EURIBOR - that would be -0.2%;

- perform a swap transaction of the currency into US$ which includes eliminating the currency risk - this will have a variable cost but lets put that at 1% - it can be more or less.

Now lets take your assumption that they can make 5% on a 100K. That would now look like this:

  •  +5,000$ income from the SPY strategy
  • - 720$ Total cost of swap/interest
  • +4,280$ profit for investors

That is a 42.80% return on an annual basis. You could be less sophisticated and just borrow monthly US$ which costs around 2.5% tops - the strategy remains the same and the return would be 25% annualised. There is still huge risk involved in this transaction even though its mitigated somewhat by the fact you trade monthly SPY. There can be a refinancing problem or interest rates could rise which would eat into your return like there is no tomorrow.

Obviously this isnt happening wholesale and so the premise of your article that you wont lose more than you win on your two losers is at fault here. Whilst you can mitigate the losers somewhat taking them at least at the triple value of a 'regular' win is already more realistic. You then have a 3% or less return which means that unless you go the sophisticated way of foreign currency swaps and the whole shebang you will find it hard to get to where you need to be.

If there was a strategy yielding standard 5% (without additional risk) today all the big money in the market would be into it. Big fortunes fear above all to make big losses and do very well on modest growth.

 

I believe the over a long time, you can make 5% with this strategy. But it doesn't mean you will make it every year - it is still possible (and expected) to have 20-30% drawdowns (which is still better than S&P). What happens if the drawdown happens right after you took the loan? The 30% loss means 30k which is 3 times your initial capital. And you have no idea how long will it take to recover.

Share this comment


Link to comment
Share on other sites
10 hours ago, FrankTheTank said:

Totally agree about the "gurus" pitching option selling as some great alternative to buy and hold without really addressing the risks (including the risk of under-performing buy and hold which is likely the case over the past 10 years).

On the positive side,  my father who is in retirement mode may be fine with a 5% annualized return that has less volatility that holding SPY and provides a diversified income stream.   I think it just depends on your goals and tolerances for risk.

 

 

Options selling strategies are likely to underperform in strong bull markets. But what will happen to your father's retirement funds if the markets tank 50% tomorrow?

The whole point of options selling strategies (like our Steady Momentum strategy) is to reduce volatility, while still producing market like returns over the long term. After all, you never know when the next bear market will come.

Share this comment


Link to comment
Share on other sites

Take a look at this article where a long time tastytrade follower pretty much confirms our estimates. He is getting to ~15% annual return by applying ~2x leverage, but I'm wondering how much risk does it add. 

Share this comment


Link to comment
Share on other sites


Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs