Good-Bye to Unlimited Risk Option Strategies

Unlimited risk option strategies get a bad rap in the investing community among newbie traders. And while our backtesting research has shown that unlimited risk positions like short straddles and short strangles generate the best overall returns, you might be restricted in trading them because of your account type or just fear the big potential drawdowns. In this podcast I want to conceptually walk through how you can convert unlimited risk strategies into their risk-defined counterparts and limit your exposure. As always, there's no free lunch in the market, so if you limit your risk you have to give up something else and we'll discuss the trade-offs on the show together.

Key Points from Today's Show:

Unlimited risk strategies have a bad reputation within the industry.
Although they seem unlimited, they can be limited by your own position size.
Trading multiple positions across multiple ticker symbols is preferred rather than one position across one ETF.
Spread your risk and keep your position size down so that no one individual trade can knock you out.
Unlimited risk strategies are the most profitable and generate the highest returns with the smoothes portfolio graph of mostly any strategy out there (see show 100).
You receive more compensation with unlimited risk strategies, despite the extra risk taken on.

Case Study

IWM is trading at $184.27. We do a regular short strangle in IWM, selling the 139 puts at 15 Delta. On the call side, sell the 15 Delta, which is the 155 alls. You would collect $122 premium to do this. In this case, the margin required is 2,260, which is a given number.

Brokers calculate their margin at expected move thresholds that the stock could potentially go in the future.
If the stock does make a big move, brokers want to protect themselves against these further STD extremes.
Therefore, by using the buying power effect, you can control your risk.
The return at expiration, if held for the full period, would be 5.39%.

Risk-Defined Strategy:

If you wanted to do this as a defined risk strategy, simply buy options further out than your short strikes. Use the $122 credit you collected from selling the short strangle to buy options further out. Do a $5 wide spread on either end, buying the $160 calls and selling the $139 puts to buy the $134 puts below the market.

Key: go out as far enough as you feel comfortable with your risk and your position size, to take in enough credit that makes it worth doing.

With a $5 wide spread on either side, credit gets reduced down to $69. This is now where you start to see the trade off, collecting less premium because you are getting a defined risk position. However, in this case it still works out to be a decent setup. The margin that is required to hold this position is just the difference between the strike prices less the premium collect, equalling $435 after commissions.

Return jumps up to 15.86% on this position.

Key: You have to determine whether you are more comfortable collecting less money but having a higher return on your trade.

Iron Condors and Iron Butterflies:

Iron condors and iron butterflies in low implied volatility markets tend to work better because they have higher returns with defined risk and you can effectively create a scenario where you have the same marginable risk as a short strangle and collect way more money in doing so. The only trade off is that your break-even points are much more narrow. This will affect the position in the sense that if the stock starts to move against you, you do not have as much cushion.

With a risk-defined strategy, you will not generally get the quicker profits as you would with a straddle or strangle.

Straddles and strangles are just single contracts, trading the short puts and the short calls.
As time decay and volatility contracts, those options will see a quicker, more violent reduction in their premium.

Iron Condor Turned Defined Risk:

With an iron condor, when its turned into a defined risk strategy, because you're not selling and buying options at the same time, the premium decays at a much slower pace. Back testing shows that short strangles and short straddles can be held for short periods of time. Therefore you have the ability to potentially recycle that capital at a faster pace. The iron condor has a higher ROI to begin with, but it also means that you have to hold the trade much longer — two or three times longer than the original short strangle.

At this point you can start adjusting your long strikes. If you want to take in the higher credit, go up to the 165 calls with a $10 wide strike on either end. That now moves the credit up to 91 cents from 69 cents. It may not be work going that wide. If you go $10 out on either end and take in credit of $91, the margin required to hold this position after commissions is $913. The return drops down to 9.9%. As you start to replicate more of the original strangle position, you start to see that the return starts to edge down towards the 5.39% original return.

Key Takeaways:

No one strategy is better than the other.
The key is understanding the tradeoff between the different strategies.
Also, be aware that you do not have to do any undefined risk strategies.
You can do defined risk strategies if you have a smaller account.
By controlling your position size and controlling your risk, you can still generate decent returns along the way.