Selling Naked Strangles: The Math

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. 

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.

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.

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.

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.

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.