Boosting Your Risk-Adjusted Returns By Selling Options

If you were to sell premium on NVDA, which is a very volatile underlying, you'll get few occurrences, huge spikes in IV and more outlier risk. Not the sort of elements I was hoping for as a conservative option seller. To put another way, although high-risk stocks offer juicy premiums, the risk is much more elevated if we get a huge move, either way up or way down.

Looking at more defensive, low-volatility business areas, our watchlist is now composed of the following sectors:

2) What Delta And Duration?

There's one golden rule when selling options on low-volatility stocks: giving yourself adequate duration to reduce gamma risk, pocket enough credit and roll out when required. The concept of selling premium boils down to a trade-off between Return On Capital (ROC) , time decay and duration. The more days to expiration, the higher the premium, but that goes with slow time decay. In other words: not enough bang for our buck (a small daily return relative to the amount of capital we have to come up with). If you focus on shorter durations, option prices are more sensitive, but you get rapid time decay on a small amount of credit. It's therefore important to opt for reasonable duration, decent ROC and width between the put and call strike.

(Source: Tasty Trade)

Let's consider PG for a second, a security on which we sold 110/130 short strangles with January 17th, 2020 as expiration date. We collected 88 dollars per strangle (one option is the equivalent of 100 shares) and it's now trading anywhere around 70 dollars. If we were to sell the 117/126 strangle expiring on December 27th, 2019, we get 103 dollars per contract but the width has narrowed considerably. If PG starts moving either way up to 126 dollars or way down to 117 dollars, we are going to get hit hard on that short-term trade. A 10-delta strangle results in an attractive ROC and high win rate. If you sell a short-term strangle it's more margin consuming than a longer-term one because of the difference in strike prices. Of course, in return, time decay is nil for long-term options. Finding a balance between margin, premium and time decay is a subjective exercise.

More time until expiration allows for the same credit, with a higher chance of success.

3) Management Techniques

* Rolling Out

One of the risks as an option premium seller is a sudden spike in IV just after you sold options. Let's say you hypothetically lose 0.5% of your portfolio value when IV rises 1%, but collect 0.15%-0.20% in daily theta. If low-volatility stocks have see a 5% surge in their IV over a one-month period, you would have lost 2.5% but collected way more in daily theta. Thus, net-net, you're still up for the month.

Increased volatility also caused the option premia for the next months to increase sharply. As such, it's critical to roll out your positions at 30-25 days before expiration, re-center your strikes and again extend duration to 60 days. Consequently, we now have rebalanced our portfolio and reduced risk. Based on the IV curve, longer term options pricing is oftentimes based on a higher IV, as shown for American Tower, AMT.

If we face heightened volatility (like in 2008), we can decide to roll out even further (by extending duration to 4 months for example) and widen out the strikes (we then get in excess of 50% of downside risk protection). That's when we're really cautious about the market and don't want to incur huge short-term losses. As the situation starts to normalize, we can re-enter our shorter-term short strangles while still benefiting from above-average implied volatility and wide profit zones.

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