Boosting Your Risk-Adjusted Returns By Selling Options

Introduction

In this article, we're going to discuss how you can optimize your short strangle option selling strategy by fine-tuning the criteria of what underlyings to use, which delta to select, what duration you should look for and what management techniques we have to control our outcomes and reduce risk. It can always be very intimidating to get started with option selling, but here at OG we want you to realize that you can improve your risk-adjusted returns significantly by selling options, as long as you know what works well to achieve that goal.

1) What Underlyings To Select?

By far the most crucial aspect to becoming a successful option seller. Industry allocation, diversification and understanding the 'nature' of the stocks you sell options on make or break your success. If you sell options on less than 15 different non-correlated underlyings, your portfolio will be a lot more volatile than expected with mixed results along the way. Having on at least 20 different positions based on sound industry diversification increases the long-term win rate and makes your returns cluster around a mean, and rather static monthly return. The more occurrences we create, the better we can deal with unpleasant situations and make mid-term projections as to how much premium we can effectively pocket as profit.

In order to minimize directional risk, it's far better to sell calls and puts simultaneously so that if the stock starts moving against your 'no-bias' opinion, you can absorb short-term variance in your return and margin requirements. When being short premium, we're short Vega, a Greek which measures the price sensitivity of an option per 1% change in the implied volatility. The more volatile the implied volatility is, the more volatile and unpredictable your portfolio returns will be. Basically, we're looking for stocks that don't move that much: low-volatility stocks. There's a phenomenon called the low-volatility anomaly which underscores the outperformance of less volatile stocks relative to volatile securities on a risk-adjusted and absolute return basis.

We always talk about or concern ourselves with what stocks will provide the best returns over a long-term time frame, thereby often chasing a double-digit annualized return. That goes with high risk, but most people firmly believe you get compensated for that. In reality, however, from a buy-and-hold perspective (and trading perspective as well since it introduces more emotional investment decisions), taking on higher risk ultimately comes at an unpleasant price. By focusing on more risk, we lose the edge of risk/reward. Why is that? Research found that there's a negative relationship between risk and reward.

From 1990 to 2011, the tenth decile of a basket of all US stocks posted much worse returns than their least volatile counterparts courtesy of fickle cash flow generation and destroying shareholder value. The least volatile stocks perform much more consistently as their cash flows are stable and their sales growth moderate. They are somewhat overlooked as very few investors have high expectations of them when it comes to posting fast and dazzling profits. Who wants to invest in boring utilities whose cash flows are being regulated and whose debt-funding system provides a lot of visibility? Instead, you should chase the newest hype and pick the next tenbaggers. Nobody has a crystal ball, but the more consistent your returns are the better you will fare during the next correction/bear market. It's about winning by not losing.

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