OAP 059: Short Strangle Case Study – Adjustment Strategy That Slashed Our Loss By 87%

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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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Free Options Trading Courses:

  • Options Basics [20 Videos]Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
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  • Pricing & Volatility [12 Videos]This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
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PDF Guides & Checklists:

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  • Implied Volatility (IV) Percentile Rank [3 Pages]A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
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Real-Money, LIVE Trading:

  • IWM Iron Butterfly (Closing Trade): Exiting this IWM iron butterfly options trade gave us a $1,100+ profit after pinning the stock price one day before expiration at the peak of our spread.
  • CMG Iron Condor (Opening Trade): I just recorded my live trading platform (and real money account) as I walked through the process of entering a new iron condor trade in CMG stock. Inside you'll see me analyze, price and fill the trade in real-time.
  • APC Strangle (Closing Trade): Took about $150 out of this small APC strangle trade even after the stock moved completely against our short call strikes this month. But as always, implied volatility always trumps direction and because IV went down, the value of this spread dropped more-so than the impact of the directional move higher.
  • IYR Call Credit Spread (Adjusting Trade): This adjustment is good for 2 reasons. First, it reduces the overall risk in the trade if IYR continues to move higher. Second, it still leaves room for the stock to fall back down into our new profit window.
  • XHB Straddle (Closing Trade): We were able to bank a $120 profit early in the March expiration cycle for our XHB straddle with the stock trading right in the middle of our expected range.
  • AAPL Call Calendar (Opening Trade): Look behind the scenes as I use our new watchlist software to filter quickly and find this AAPL call calendar spread trade during overall low implied volatility in the market.
  • COF Strangle (Adjusting Trade): Here I recorded my live trading screen (and real money account) showing you the entire thought process we used to make an adjustment to my current short strangle in COF to reduce risk.
  • GDX Strangle (Opening Trade): With gold's high IV we are getting into a new strangle with a 70% chance of success and a decent credit for selling option premium.
  • IBB Iron Condor (Closing Trade): Today we're exiting an iron condor we traded in IBB for a $142 profit. Inside you'll see me analyze the exit price and fill the trade in real-time.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.