Short Strangle Case Study – Adjustment Strategy that Slashed Our Loss by 87%

This episode helps you understand the overall adjustment philosophy that helped cut losses and turn a losing short strangle trade around.
Short Strangle Case Study – Adjustment Strategy that Slashed Our Loss by 87%
Kirk Du Plessis
Aug 29, 2016

It's easy for traders, myself included, to talk about our profitable trades. I mean who doesn't want to talk about making money right? But we know that we can't win on every trade and today I'm going to cover an in-depth case study on our EWZ short strangle.

We started building the EWZ position with short strangles back in late November and ending making more 27 trades over the course of five months to adjust and hedge the position. It was by far one of our longest held positions, but at the end of the five month period we ended up turning a paper loss of $2,538 (the most we were losing at any one point) into a real loss of just $330. An 87% reduction in the loss.

It took a lot of confidence in our adjustment strategy as well as patience to let the market cyclicality play out, and my hope is that today's show helps you understand the overall adjustment philosophy that helped turn this trade around. Sure, it would've been great to highlight a case study where a trade went from a loser to a winner. That just wasn't the reality with these short strangles, and yet, I'm still happy with the results even though we lost money after everything. Plus, if it helps you avoid or reduce risk on the next options trade you make, well then I've accomplished my mission.

Key Points from Today's Show:

  • The strategies we implemented in this trade helped cut our loss by 87% — took a trade that was losing $2,500 and cut the loss down to $330.
  • When a position is a losing trade, the concept of how you adjust and the rationale behind it can absolutely save you thousands of dollars over your lifetime of trading.
  • Backtesting shows that the overall philosophy that works out more often than not is that you do not touch the side of the trade that the market is moving against — the call side in this case study.
  • In a losing trade, there are two aspects that will work to your benefit; one is having a small position and not adding to it. Second is trading an ETF, which has more flexibility and less risk than stocks.
  • The key is to continue to maintain the small, manageable position which allowed you the flexibility to keep rolling the contracts out month to month.
  • Keep in mind that the best strategy is to keep the duration of the trade long while waiting for the market to normalize, and continuously taking in a credit by making adjustments.
  • If you are making adjustments to your position, you have to get compensated for making that adjustment. This helps widen the breakeven points out on either end.
  • The key is not taking what the market forces upon you. The person who is more patient and can hold through the initial move that created the loss on paper will be okay.
  • Continue to hold onto the position keeping in mind that two things were going to happen; the stock and the implied volatility will come back down, and the market will normalize.

Short Strangle Case Study on EWZ (November 2015 - May 2016):

  • Monitored, start to finish, the adjustments that we made in EWZ over a five month period of holding this position, that slashed our loss by 87% — took a trade that at one point was losing $2,500 and cut the loss down to just $330.
  • The position in EWZ was a cumulative position that we started building over five months and then closed. This is our longest trade position that we have had to date, that we continuously had to manage.
  • Started when EWZ had dipped down to $18 from the mid-30’s. As it was coming down, implied volatility spiked up to 80th rank.
  • During the five-month period, EWZ went from $18 all the way up to $30. When we finally closed out on 5/18, it was at $26.
  • A critical action was that we did not add to the position after the market went against us. Maintained the small, manageable position which allowed us the flexibility to continue to roll the contracts out.
  • Another thing that helped was that it was an ETF. With ETF's you have much less risk with a huge move higher than with stocks, therefore we expected more market cyclicality with EWZ.
  • First two positions were January/February options, and we started selling some strangles. Continuously sold strangles in EWZ — 26 calls and 19 puts, $55 credit on each of those in a basket of three.
  • At the end of the February expiration cycle, EWZ went from $20 up to $26 in 5 days. This is a huge move we did not anticipate, and implied volatility did not go down, it increased.
  • Early in March expiration, we started adjusting our position — adjusting the side of the trade that the market is moving away from, rolling our put strikes higher to collect more premium. The premium helps widen the break even point on the top side of the trade.
  • During the April expiration cycle, implied volatility spiked up to around the 100th percentile in level. Since the implied volatility was so high we rolled our contracts to the next expiration period.
  • This roll from April to May we took in a huge credit across the board because we were rolling into the highest implied volatility that was seen in the last year — premiums were double what we collected last time.
  • Implied volatility was cut in half after the April expiration, which finally allowed all the premium that we had been collecting to finally collapse and eat away at the loss that we had, seemingly over night.
  • On 5/18 we closed out of everything, liquidated the rest of the position, all of the contracts, everything after the stock came back down from $30 down to $26.
  • We were able to cut our losses by 87% because of keeping the duration long, waiting for the market to normalize, and continuously taking in a credit through adjustments — rolling up puts and rolling entire strategy out from month to month.
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