Managing losers can reduce losses from very large drawdowns but we feel the average performance is compromised because it locks in losses. Our research team designed a study to put some hard data behind our belief and it both explains why managing earlier produces better results and how to put that knowledge to use.
Our study was conducted in the SPY (S&P 500 ETF) using data from January 2005 to the present. Using the option expiration cycle closest to 45 days to expiration (DTE) we sold a 1 Standard Deviation (SD) Strangle. We opened a new position only after closing the old one. We allocated 25% of the available capital to selling these Strangles and determined if the average performance could be increased by managing losers at levels between 1 and 5 times the total credit received.
A graph of the results showed that managing losers underperformed a SPY buy-and-hold strategy by 40%. A table displayed the total number of losing trades at 1x, 2x, 3x, 4x, and 5x the credit received and more importantly, the the number of losers that occurred earlier than 21 DTE at each level. The number of losing trades, at these multiples of the credit received, that were losers before 21 DTE, was extremely low or zero.
Tom explained, “Almost all the losers occur when the Gamma risk is the greatest, in the second half of your trades. All the risk is when the premium starts to accelerate. So, let's eliminate that risk up front by getting out of these trades earlier. That eliminates the Lion’s share of all your risk.”
Another table displayed the average P/L increase per contract obtained by closing the trade 21 DTE before expiration. The superiority of closing the trade before 21 DTE was displayed in a graph of running P/L. It clearly outperformed buy-and-hold and beat the average of managing losers by almost 200%.
Tom added, “This study has nothing to do with high IVR. If you segregated and allocated by high IVR, your performance would be significantly greater. This is the true validation on how to be successful.”
For more on Managing Losers see:
Market Measures from September 1, 2015: "Short Puts | Managing Winners & Losers"
Market Measures from July 5, 2016: "Managing Losers or Managing Earlier"
Market Measures from August 19, 2016: "Manage Losers?"
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the valuable takeaways and the "game changer" results of our study on managing losers at a multiple of the credit received and on managing earlier as an alternative strategy.
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