Correlation And Short Vega: Let's Do The Math

Correlation: Diversification Makes The Most Sense For Premium Sellers

Selling strangles is always referred to as being risky as we have downside and upside risk. However, we can actually throw the odds into our favor not only by enjoying high probability of profit (a realized 90%+ for 10 delta strangles, versus 55% for buy-and-hold investing) but selecting different, non-correlated assets to keep our portfolio volatility to a minimum. If you are a common stock investor, spreading the risk via purchasing bonds and stocks does reduce your standard deviation, but it doesn’t provide you with additional returns as bonds and stocks show strong negative correlation (they are counterparts that will smooth pronounced movements out). But what about selling short strangles on these assets? Can we reduce our risk by setting up delta-neutral strategies with wide profit zones, regardless of whether we were wrong or right about the direction (let’s say you are bullish on the SPY and bullish on TLT, can you make enough money if you’re completely wrong about their future price action? By selling strangles on the major American indices from 2005-2018, we did post smoother returns.

Looking at the ETF correlations, things get even better…

By selling 1 SD strangles (16 delta on each side) on all sector components, we significantly reduced our correlation to the S&P-500 whereas buying them outright doesn’t provide you with additional returns or lessened volatility. This is really cool and it’s the primary reasoning behind why I have on a cell tower REIT position, storage REIT, Chinese and American e-commerce underlyings, software company, air-conditioning manufacturer, medical equipment producer et cetera. Buying healthcare companies outright resulted in a massively positive correlation of +0.80 to the S&P-500, but by selling wide strangles there's almost no remarkable correlation (we now sell 10 delta strangles so the relationship between healthcare and the entire market performance should disappear completely). This makes total sense from a risk management point of view, yet very few investors pay attention to it and look at just the beta values alone.

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