You're ready to place an option trade and you're confident the stock is a good candidate. Now what? With dozens of contract months and hundreds of option strike prices to choose from - which ones do you select? In today's podcast, we'll help bring some more light to the "dynamic approach" we now use at Option Alpha for each and every trade we place. The framework and concepts around dynamic contract month and option strike price selection can help dramatically improve your long-term performance and reduce portfolio volatility.
Key Points from Today's Show:
- There is no one consistent framework that works across all trading scenarios; everything has to be dynamic.
- When you have more information, tweak and adjust your trades based on factors like option month, time until expiration, strike prices, etc.
- Every trading environment will be slightly different from the next, especially if optimization is the goal.
- Optimizing your trades will give you a lot more bang for your buck than simply using on single strategy throughout.
- The key to understanding which strategy to use is to back-test your trades.
Case Study
Back-tested 10 years of data on an EWZ short straddle. EWZ is the Brazil benchmark ETF; very liquid with some volatility in it. This is a great trading vehicle to gain exposure to overseas markets and to Brazil.
Basic setup across all four variations:
- Started with a portfolio of $250,000.
- Trade frequency was always weekly - entered a new trade every single week, when possible.
- Standardized the overall allocation, using 10% of the portfolio.
- Took profits at 25%, which is a standard benchmark for short straddles.
- Had no stop loss in place and no IV rank filter.
- Took a hyper-focus on both days to expiration and the short strikes or Deltas that were selected.
Setup 1:
- 30 days to expiration time period, short strikes at a 50 Delta - selling the at the money strikes.
Results: Trade lost $15,000, dramatically underperforming the market.
Setup 2:
- 30 days to expiration time period, short strikes at a 40 Delta, slightly out of the money - selling a tight strangle (straddle synthetic).
Results: Trade made $30,000, creating a $45,000 difference in your P&L.
Setup 3:
- 60 days to expiration time period, short strikes at a 40 Delta.
Results: Trade lost $80,000, creating a dramatically different payoff diagram.
Setup 4:
- 60 days to expiration time period, short strikes at a 50 Delta - the true short straddle.
Results: Trade lost $41,000.
Conclusion:
- When you change one factor, it does not mean that you can automatically assume that if the other factors remain the same that it will produce the same result.
- The 60 days to expiration contracts behave differently than 40, 30, and 20 days to expiration contracts.
- Contracts behave differently and pricing is different in high IV versus low IV environments.
- Your portfolio and sequence of returns are dramatically different when you allocate 50% to a trade and have 5 losing trades in a row than if you allocated 10% and have 5 losing trades in a row.
- There are a lot of moving parts to consider in each trade, that requires smart decisions and rational thought.
