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Here is a snapshot of the discussion: Lets examine two cases, using the same underlying (BABA). Credit spread Lets say you decided to sell 130/135 credit spread for $1.00 credit. The P/L chart look like this: As we can see, the margin requirement is $400 (the difference between the spread width and the credit), the maximum gain is 25% and the maximum loss 100%. Maximum gain is realized if the stocks stays below $130 by expiration and both options expire worthless. maximum loss is realized if the stock is above $135 by expiration and both options are ITM. In this case your loss is the $5 less the $1 credit. Short Strangle Now lets see what happens if we try to sell a naked (short) strangle, using 110 puts and 140 calls, for the same credit of $1.00. Here is the P/L chart: As we can see, the margin jumps to almost $1,250. Maximum dollar gains remains the same ($100), but return on margin is reduced to only 8%. If you sold the strangle for $1.00 and bought it back for $0.75, you made $25, which is around 2% return on margin. Here is a general guideline how to calculate ROI on credit spreads. Let say we open a 10 point wide credit spread (i.e. there are 10 points between the sell leg and the buy leg for the credit spread) The broker requires $1000 of maintenance margin to open this credit spread. When we open this credit spread for $2.00 credit, or $200. Our risk capital is then $1000 – $200 = $800. The potential ROI is then $200/$800 = 25%. If you close the trade for $1.00 debit (50% of the maximum gain), your gain is 12.5%, not 50%. Why it is important you might ask? Well, lets say you have a $100k account and decide to allocate 10k (or 10%) per trade. If you allocate 10k per trade and make 25%, you would expect to make $2,500, so your account grows by 2.5%, right? Well, in case you sold the naked strangle, you can sell only 8 contracts based on the margin and your allocation. When you buy the 8 contracts back for $0.75, you make $200, which is 2% gain on $10k trade. If you are still not convinced, here is another way to look at it: When you sell a $5 wide credit spread and get $1 credit, you risk $4 to make $1. Your risk/reward is 1:4 - you can lose 100% and make 25%. When you sell a $10 wide credit spread and get $1 credit, you risk $9 to make $1. Your risk/reward is 1:9 - you can lose 100% and make 11.1%. I hope you can see how margin impacts the returns when you are selling options. Related articles: Selling Strangles Prior To Earnings Selling Naked Put Option Karen Supertrader: Too Good To Be True? How To Blow Up Your Account
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. 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 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.
I was taught that one of the assumptions used in this strategy is that for the most part, the market has all ready priced the option correctly for the upcoming news so by allowing for some price movement within your strangle, this is more of a volatility play than a price play. Mark's response: 1) To me they are the same, with the straddle being a subset of the strangle In other words, a straddle is merely a strangle when the strikes and expiration dates are the same. I prefer the strangle because it allows the trader to choose call and put strike prices independently, rather than being 'forced' to choose the same strike. I prefer to sell OTM calls and puts – and that's not possible with a straddle. As far as unlimited risk is concerned, that's a decision for each trader. I prefer the smaller reward and increased safety of selling credit spreads (an iron condor position), but that is not relevant to today's post. 2) A clarification. In is not 'volatility' that incurs a large decrease after the news is released. Instead it is the implied volatility of the options. I'm fairly certain that is what you meant to say. 3) Your earnings plays are far riskier than you currently believe them to be. These are not horrible trades, but neither are they as simple as you make them out to be. 4) I must disagree with whomever it was who told you that "the market has priced the option correctly for the upcoming news." The market has made an estimate of how much the stock price is likely to move. Note that this move may be either higher or lower ad that this difference is ignored when the size of the move is estimated. There is no formal prediction of move size. There is nothing that says the stock will move 6.35 points. What happens is the implied volatility rises as longs as more and more buyers send orders to purchase options. And it makes no difference if they are calls or puts. At some point option prices stabilize (or the market closes for the day) and a 'final' implied volatility can be measured. From the IV, the 'anticipated move' for the underlying is determined. AsI said, it's not as is everyone agreed on how much the stock will move. I hope you understand that when the news is released, there is very little chance that the predicted move is the correct move. Many times the move is far less than expected. That's the reason why selling options prior to earnings can be very profitable. The IV collapses because another substantial price change is NOT expected and there is no reason to pay a high IV to buy either calls or puts. However, if you chose to sell an option that was not very far out of the money (OTM), and if the stock moves far enough, then the IV decrease doesn't do a whole lot of good. Sure you gain as IV plunges, but you can easily incur a substantial loss when the short option has moved significantly into the money. Also remember that part of the time thet stock price gaps by far more than expected. In that scenario, a higher quantity of formerly OTM options are now ITM. Thus, large losses are not only possible, but they are more frequent that you realize. Apparently your trades have worked out well (so far). Think about this: If those option buyers did not profit often enough to encourage them to pay 'high' prices for the options they buy, they would have stopped buying them long ago. The truth is that these option buyers collect often enough to keep them coming back for more. 5) That means you must be selective in which options you sell into earnings news. This is especially true when you elect to sell naked options. You cannot options on every stock, hoping that any random play will work. This is a high risk/high reward game. It's okay to participate, but please be aware of what you are doing and the risk involved.
Karen the "SuperTrader" has generated a lot of curiosity in the trading community. She has been interviewed on TastyTrade twice. The title of the last interview was .Is she real? Does she really generate all those outstanding profits? Some people think Karen is a fraud. This article aims to clarify some facts about Karen SuperTrader and her trading results. Click here to view the article