Selling cheap options with very high probabilities of success makes sense on the outside. I mean, why sell options with a 70% chance of success when you can sell options further out that have a 90% chance of success? No brainer right? Well, not so fast. The options market is fair and efficient, and selling these far out-of-the-money options might look good from a win rate perspective, but the total dollar profits you'll generate far under-perform the stock market. Today, we'll use our Options Backtesting software to run two option selling strategies on TLT. The first test sells options at the 0.25 delta and the second backtest sells options at the 0.05 delta. We present the results and our analysis as to why selling cheap options could be less beneficial to your portfolio.

Key Points from Today's Show:

In episode #102 we looked at different options prices and dug down into particular contract months for S&P call options.

• Tested the 40, 30, 20 and 10 Delta options.
• Looked at the differential between pricing and how far out they were from the money, probabilities of expiring in the money, etc.
• This topic goes hand-in-hand with today’s episode.

In today's show we look at a back-tested case study of a TLT strangle.

• The strategy works across different ticker symbols and highly liquid ETFs.
• The concepts and framework generally work across everything that we are trading.
• We can use TLT to help prove this specific concept.

Often times when traders discover that they can sell options and generate a high probability of success, the natural default is to sell the cheapest options furthest out.

• These are the options with a 90% chance of being in the money.
• The problem with trading cheap options that are so far out is that although cheap options have a high probability of success, they have dramatically lower profits overall.
• The key is not to look at just the total win rate, but rather to look at total dollars generated.

Case Study:

Set up weekly short strangle entries on TLT (a bond ETF), targeting 40 days until expiration. There was no IV filter in place, no profit taking, and no stop-loss — pure set it and forget it trading. Simply set up the trade and let it go all the way until expiration, win, lose, or draw — no adjustments, no rolling. The only changes made were in the short strikes that were selected.

Setup 1:

On the first run, sold options at the 25 Delta on either side. Theoretically, this trade should be a 50/50 winner. At best, this is set up for a 60% win rate.

Results for Setup 1:

• The strategy won 70% of the time, overshooting expected win rate by at least 10 points.
• That differential is because of the implied volatility's overpricing, because the market doesn't move as far as we would have thought.
• The strategy generated a 40% return over the last 10-11 years.
• Total profit on a $250,000 portfolio was a little over $100,000.
• The annual CAGR was 2.46%
• Performed very similar to the S&P, but had dramatically less variance.
• During 2008 and 2009, the portfolio did not take as much of a dip as it would have in equities.
• The variance in the account and the stability of the strategy was much improved over the S&P.
• The max draw-down at any one point in the whole cycle was 27%, again, better than the broad market.

Setup 2:

Same setup as setup 1, with a tweak in the short strikes. Went much further out on the short strikes and sold the 5 Delta calls and the 5 Delta puts on TLT. This strategy should win 90% of the time. Again there was no IV filter, no profit taking, and no stop-loss.

Results for Setup 2:

• The strategy won 92% of the time.
• The further you go out in selling options, the less often the strategy is going to out-perform what it should do.
• At some point you will hit 100% or 99% chance of success if you sell options very far out.
• There is a diminishing return factor where if you sell options further out, the win rate starts to slowly creep down.
• Since you are selling options so far out to begin with, the strategy only won 2% more than the probabilities suggested.
• The draw-down was 13%, which is consistent with a strategy when you win more often.
• However, total profit made and total returns dramatically under-performed the market.
• There was a 17% return over the entire period.
• Annual CAGR was 1.61%.
• Total dollars earned on a $250,000 was just $43,000.

Conclusion:

• When you sell options that are closer in (15-25 Delta range), you generate more total dollars than you would if you just defaulted to selling options very far out of the money.
• Although selling options far out of the money has a really high win-rate, it consistently under-performs the market and generates less total return.
• Back-test and optimize your trades, trading within a framework and using it to your advantage.