Our research team has conducted numerous studies. They show that a strategy of selling premium in the form of Short Strangles on an equity index has performed very well historically. This is because the expected move derived from the Implied Volatility (IV) of the options is usually overstated. The resulting issue to be resolved is the sizing of the positions. A portfolio leveraged 100% with Strangles is highly unlikely to survive the drawdowns. A portfolio that doesn’t risk enough is wasting opportunity, and the return on capital (ROC) won’t be high enough to make it worth it. So what should be our capital utilization in our account if we are selling Strangles?
Our study was conducted in SPY (S&P 500 ETF) from 2005 to present. We sold Strangles at the beginning of each month. We sized the position to use ⅓ of the account’s available buying power in order to avoid a possible margin call in the event of a drawdown. We held the trades until expiration. We closed the position if the Buying Power Reduction (BPR) increased to more than 80% of the net liquidation value of the account. We compared this to a strategy of buying SPY shares using 100% of the portfolio’s capital.
A table comparing long SPY stock to a short Strangle portfolio was displayed. The table compared the average weekly return, weekly Standard Deviation of Returns and annualized growth. The Strangle portfolio had higher weekly returns with a lower weekly standard deviation of returns. An 11 year graph comparing a Strangle Portfolio to a 100% long SPY portfolio indicated that the Strangle portfolio outperformed the long stock portfolio and performed the best in periods of high IV and choppy markets. An 11 year graph of the target capital utilization showed that the Strangle portfolio strategy has a negative in that the SPY Strangles are becoming too large, so capital is being underutilized. The graph implied that traders need to supplement their account with a variety of strategies and underlyings to fit their portfolio size.
For more on Capital Allocation see:
Strategies For Your IRA from August 17th, 2015: “Capital Allocation Awareness”
Strategies For Your IRA from August 26th, 2015: “Capital Allocation In Small Accounts”
Strategies For Your IRA from May 24th, 2016: “Dynamic Iron Condors: Capital Allocation”
Watch this segment of Market Measures with Tom Sosnoff and Tony Battista for the important takeaways and the results of our study on the proper utilization of capital when using a strategy of shorting Strangles.
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