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  1. Many alternative portfolios have been devised to beat the 60/40 portfolio on a risk-adjusted basis, but few have succeeded over the long-term. The death of the 60/40 portfolio is often proclaimed by many in the industry, yet it’s often by those with competing products. In this article, I’ll present a simple idea for active option traders to enhance the 60/40 portfolio instead of compete against it. Short Strangles Short strangles are a multi-leg option strategy typically written around one month from expiration by combining an out of the money (OTM) put with an OTM call. This creates a profit zone at expiration where the goal is for the underlying asset to finish in between the strike prices so that the entire option premium collected is retained as profit. What’s unique about selling options is how no cash outlay is required, only a collateral requirement known as margin. This presents opportunities for creativity. With a 60/40 allocation as the underlying portfolio, the short puts can be collateralized by bonds and the short calls can be collateralized or “covered” by stocks.60/40 with a short strangle overlay effectively combines covered calls with cash secured puts. Portfolio Example A specific example could be using a fund like Vanguard’s balanced index fund (VBIAX) as the underlying 60/40 portfolio. This fund maintains a US based 60/40 asset allocation all in one low-cost fund with a track record of 8.6% annualized average return since 1992. An active trader could then enhance this base portfolio in an options approved margin account by writing SPX, XSP, or SPY strangles on top of a portion of the VBIAX position. If a trader targeted a 30% notional allocation for the strangles, the short calls would be fully covered by the underlying equities and the short puts would be fully collateralized by the underlying bonds. Short strangles have a historical risk profile that exhibits low beta to both stocks and bonds during most market conditions, which adds diversification to the portfolio. Although a strangle overlay increases total portfolio risk it’s likely to increase returns by a greater degree that should result in a higher expected Sharpe Ratio. Stay Tuned In a follow up article, I’ll present historical data that illustrates the concept in more detail. I personally find this portfolio compelling as it’s simple to manage and relatively tax efficient due to the buy and hold nature of the underlying 60/40 portfolio and the 1256 contract treatment of the option strangles when using a cash settled index like XSP. The portfolio blends together three distinct sources of returns in stocks, bonds, and option selling. It also blends passive investing with active trading in a well thought out manner. Like a good recipe, the ingredients taste the best when combined together. 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. Related articles Selling Naked Strangles: The Math Selling Short Strangles And Straddles - Does It Work? Bullish Short Strangles Does “Managing Winners” Add Value To Short Strangles?
  2. Thanks to the help of a Steady Options member who deserves the credit for co-creating a web based backtesting tool with me, I can quickly test varying short strangle techniques on SPX options from 2001 to May 2020. Management at 50% credit My first test will use the aforementioned parameters. Specifically: Symbol: SPX Time Period: 2001-May 2020 Strategy: 16 Delta Short Strangle, excess returns only Entries: Expiration closest to 45 DTE Exits: At least 50% of the credit received or a 21 DTE time stop, whichever occurs first Slippage and Commissions: None Position Sizing Rule: 1x notional compounded growth of $1 million Trade reentry: Next trade entered immediately after closing current trade Data frequency: End of day Results… CAGR: 4.44% Annualized Volatility: 8.62% Sharpe Ratio: 0.52 No management My second test will use more conventional parameters. I’ll list only variables that differ: Entries: Expiration closest to 30 DTE Exits: 5 DTE time stop Results… CAGR: 5.46% Annualized Volatility: 8.19% Sharpe Ratio: 0.67 The results favor the second approach in this sample period, which is passively managed with just an entry and DTE exit. Note that holding until expiration produces similar relative performance results from additional tests I’ve completed using ORATS. So why do many option educators confidently promote active management as a source of additional expected return? The devil seems to be in the data, as the results from my backtesting differs from that which I’ve seen in the articles and videos from others. Do your own homework and form your own opinions, as option backtesting is time consuming, expensive, and difficult to replicate the results of others due to the number of variables involved. Slightly Bullish I do find that setting up a short strangle with a modest long bias improves results, which is also counter to what many suggest by recommending either a delta neutral or slightly short delta trade launch. Although a short delta setup “leans into the pain” of a short vega trade, it ignores the equity risk premium (upward drift of equity market prices over time). A slight long bias adjusts for this well documented factor. We can see this in my final test where all variables are held constant as in test number two with the exception of increasing the short put delta from 16 to 25. Strategy: 25/16 Delta Short Strangle Results… CAGR: 6.30% Annualized Volatility: 9.93% Sharpe Ratio: 0.63 Conclusion Short strangles on the S&P 500 appear to have been a winning trade for decades. They experience occasional large drawdowns, which would be expected from a strategy that resembles an insurance like risk profile. To continue your own strangle trading research, CBOE has a direct link to an excellent paper from Parametric that I recommend for further reading, “Volatility Risk Premium and Financial Distress”. The author of the paper concludes “The conclusion of the study is unambiguous. Investors may benefit significantly by taking advantage of the Volatility Risk Premium at all times.” A key consideration to any trade strategy is the fundamental rationale for why a strategy naturally has a positive expected return. If it requires skillful active management of when to get in and out, I’d advise caution as it’s difficult to differentiate luck from skill in financial markets. Like passively owning index funds, market participants efficiently set option prices in a manner that creates positive expected returns for strangle sellers, and it’s unclear whether active management adds or subtracts from expected returns. 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. Related articles Selling Naked Strangles: The Math Selling Short Strangles And Straddles - Does It Work? Building a Short Strangles Portfolio Bullish Short Strangles Iron Condors or Short Strangles?
  3. Jesse

    Bullish Short Strangles

    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: 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. Related articles: Selling Naked Strangles: The Math Selling Short Strangles And Straddles - Does It Work?
  4. Assumptions: $100,000 account. Sell SPY 10 delta calls and 10 delta puts. Use options expiring in 30 days. Base the number of contracts on "notional exposure", not margin. 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: Please note that our total credit is $676 (assuming we can get filled at the mid point). 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: 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: 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: Do 80% Of Options Expire Worthless? Selling Options Premium: Myths Vs. Reality Karen The Supertrader: Myth Or Reality? Karen Supertrader: Too Good To Be True? How Victor Niederhoffer Blew Up - Twice The Spectacular Fall Of LJM Preservation And Growth James Cordier: Another Options Selling Firm Goes Bust
  5. It's All About Leverage and Margin The author is mentioning some low priced gold options: "So, you're recommending the August $1,100 puts. That gets us out there far enough, decent premium, $500. The margin is less than 2 to 1. So, you're taking in about $500-600 for each one you sell. The margin requirement is about $800-900. It's a quite small margin requirement to hold this position, and it makes it quite easy to put in a portfolio. Once you put it on, if that value does start decaying, the margin requirement goes away with it. So, your margin requirement drops" What Mt. Cordier forgets to mention is that if the position goes against you, the margin actually increases. It can double, or triple, in a very short time period. Also, one contract gives you control on $120,000+ of gold futures. Based on margin requirements, that's over 1:100 leverage. The article implies that those strategies are almost free money. And then there is no mentioning of risks at all. ZERO. Anyone who was reading the article could see this coming. The writing was on the wall. But the really scary part came about two weeks later. Catastrophic Loss Event On November 15, 2018, OptionSellers.com notified its investors in an email entitled “Catastrophic Loss Event” that it not only lost all their money, but that they would also owe money to Intl FC Stone for margin calls. According to OptionSellers.com, they lost a substantial portion of their investors’ assets due to a short call position in natural gas that, according to Optionsellers.com “was so fast and intense that it overwhelmed all risk measures in place.” Mr. Cordier then informed investors that they have a debit balance in their accounts which they need to bring back to zero by paying INTL FC Stone the difference. So, in addition to trying to process the news all their money is gone, they also have INTL FC Stone breathing down their necks demanding they pay the money they owe for its margin calls. According to Investors Watchdog,Tampa-based OptionsSellers.com touts itself as premier and highly experienced commodities options trading firm. The firm’s president and head trader, James Cordier, explained in a recent interview: “Our goal is to take an aggressive vehicle and manage it conservatively.” Unfortunately, Mr. Cordier did not trade options conservatively. It traded “naked” rather than “covered” options, leaving investors subject to unlimited exposure. This unlimited exposure is what caused to lose all their money and more in the last few days. Thus, OptionSellers.com and its principals negligently engaged in a risky trading strategy that was unsuitable for its clients and breached its fiduciary duties to them by putting its interests ahead of its clients. What Happened? This is a pretty good explanation from Palisade Research: James Cordier blew himself up by selling naked call options on Natural Gas. . . Mr. Cordier with his expert financial opinion thought it was wise to sell naked call options on Natural Gas. The thesis was that the 2018 winter was expected warmer than previously thought. And with the over-supplies of Nat Gas coming in from higher prices – Nat Gas would weaken over the next few months. So Mr. Cordier made a bearish bet on Nat Gas by writing naked call options. Remember – a naked call option is when a speculator writes (sells) a call option on a security without ownership of that security. It is one of the riskiest options strategies because it carries unlimited risk. . . He thought that he could take advantage of the ‘peak’ natural gas price two ways. First – since Nat Gas prices were up recently, he could sell options for higher premiums as bullish investors came in. Giving him more upfront profits. And Second – he believed that Nat Gas prices peaked. And would soon turn south. Which meant the options he sold would expire – and he would be off the hook. And at the very least – he didn’t think Nat Gas prices were set to go that much higher. But they did. . . Nat Gas shot up nearly 20% in a single afternoon last week – to its highest price since 2014. Some say that the added buying sparked a ‘short-squeeze’ – when a heavily shorted stock or commodity moves sharply higher, forcing more short sellers to close out their short positions. Soon after the smoke cleared he had to break the news to investors and clients. He sent a letter – and made a video apology (you can watch it below) – telling everyone about the unfortunate “catastrophic” situation. The Numbers Our contributor Chris Welsh provided some real numbers how those catastrophic losses were possible: Traditionally you can get about 16x leverage trading oil futures contracts, based on the margin requirements (though with oils recent major drop offs those margin requirements are now higher). Using some actual older prices, this means to open a $90,000 oil and gas position, each account would have to only invest $5,610. So if an account had $56,100 in it, he could purchase a position worth $900,000. Then if the price of oil goes up 1% (and he's long) then his investment would go up close to 16%. This is not abnormal, and exists in the normal option trading we do too. However, that is just really, really, really poor risk management to use that much leverage. Which gets us back to those pesky margin requirements. Margin is NOT static. So If I bought that $90,000 position for $5,610 of margin, when the price starts moving against me, I have to put up more margin, because the risk to the position increases. It's not uncommon to see margin requirements double, or triple, in a very short time period. Well his margin requirements went THROUGH THE ROOF. That $100,000 account now had a margin requirement of over $100,000. This means he's now subject to a margin call and has to either liquidate positions or put more cash up. He did neither, which means all those accounts got forcible liquidated....but after the prices had moved even more. Now that $100,000 account has a value of -$50,000, of which the owner is responsible for putting up. And since these are separately managed accounts, that means each separate "investor" is responsible for their share. These things only happen to people that don't understand risk or don't care or are idiots or are greedy idiots....or fill in your superlative here. One of OptionSeller.com clients shared his statement for 1mln portfolio where you can see all his positions. The level of leverage is just scary. Is Selling Options Really Superior? In his interview from couple years ago, James Cordier said: "Once I realized that 80% of them expire worthless I started selling commodity options instead of buying them." Not only this is factually not true (according to CBOE, approximately 30%-35% of options expire worthless), but this is also completely irrelevant, as we demonstrated in our article Do 80% Of Options Expire Worthless? This is an argument used by many amateur traders, and also by some options trading "gurus" to attract new subscribers. Even if the "80% expire worthless" myth was true, it doesn't matter - if you gain little when options expire worthless but lose big when they go in the money, your bottom line is still negative. But the most important thing is that most options are not held till expiration. Selling options has its advantages and disadvantages, so is buying options. It's not about the strategy, it's how you use it. Saying that 80% of the options expire worthless is like saying that 100% of the people eventually die. "Experts" like James Cordier should know better. And maybe he does - but those claims definitely helped him to attract new money from people who don't know any better. The fact that those people are considered gurus and are featured on CNBC, WSJ, Bloomberg and MarketWatch is scary. The Lessons James Cordier is obviously not the first money manager who blew up his clients accounts (or experienced catastrophic losses). Victor Niederhoffer, Karen Supertrader, LJM Preservation And Growth Fund.. there are probably many others less famous. 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 occasional losses. We warned our readers about the dangers of naked options and leverage on several occasions. As our contributor Jesse Blom mentioned: All 3 of these examples, and the newest one, share the common element of leverage. Excessive leverage, and also lack of diversification. Strategies like naked option selling work fine if you ignore margin requirement and view risk based on notional exposure. Parametric's VRP paper shows how a SPX naked strangle has been less risky than owning the underlying index when sized based on notional exposure. For example, that means selling 1 SPX strangle per ~$265,000 of capital today. But in this case, James Cordier took commodity futures (NG) which is itself a leveraged instrument, and applied even more leverage using naked options. Here are the elements that contributed to the failure: Using highly leveraged instrument like Natural Gas futures. Writing naked options that have theoretically unlimited risk. Using leverage on already leveraged instrument. No diversification. Using no hedging or risk management. The result was disastrous and inevitable. It always is when someone is using extreme leverage like this one. As one of our members wrote: "People see these crazy returns and think these personalities are doing something magical when really most are just levered to the hilt and taking dumb risk when there are several reasonable ways to hedge". One macro hedge fund founder faulted both Cordier and his investors for the outcome. “The nature of the strategy is that you make a little bit of money until you blow up. The probability of losing it all is fairly significant. With derivative contracts — if you don’t understand them — you really need to give money to someone you trust, and to couple of them. Have some checks and balances.” OptionSellers.com “basically took advantage of guys who didn’t know any better. I instantly thought of my grandmother, my grandfather. I honestly was thrown when I heard about it.” Conclusion To add insult on injury, it turns out that James Cordier enrolled his clients into managed accounts and not a fund. This was the reason why his clients not only have lost all their money, but that they also owe money to their broker for margin calls. As Chris explained: The media keeps referring to this as a "hedge fund." But that is NOT what it was. It was 290 separately managed accounts, all trading the same strategy. Whereas a hedge fund is an actual "company," typically a limited partnership or limited liability company, that insulates investors from losing more than they invest (unless specifically structured to make investors liable, which is VERY rarely done). The wheels started coming off here. Since these are block accounts, that means EACH client owns their own accounts and is responsible for them. So if he loses MORE than is available in the account, the account owner gets the bill....not the fund "manager." Should we feel sorry for the Mr. Cordier? There is no sympathy from Josh Brown, the Reformed Broker: Some people made me aware of how he was marketing this fund. He called it a retirement strategy. It’s not a retirement strategy, it’s speculation. I don’t feel bad for James Cordier, or his “clients.” Taking in premiums from selling calls – picking up nickels – and having no idea of the potential for a blow-up is the most childish thing I’ve ever heard. No, the laws of risk and reward are not repealed just because someone sounds sophisticated when discussing derivatives. Risk cannot be eliminated, only transformed. This man sold investors a lie. And now he compounds it with a new lie – “a rogue wave came along and capsized us!” GMAFB. Google this guy’s sales pitch when you get a chance. If your strategy bets on the movement of commodities and it isn’t durable enough to survive the movement of commodities, perhaps you have no business managing money in the first place. So no, no sympathy. Fuck you and your cufflinks too. “The problem with experts is that they do not know what they do not know.” ― Nassim Nicholas Taleb. Related articles: How To Blow Up Your Account Karen The Supertrader: Myth Or Reality? Karen Supertrader: Too Good To Be True? The Spectacular Fall Of LJM Preservation And Growth