Skewing Your Short Strangles When Markets Are At All-Time Highs

In the world of selling options, we want to minimize daily portfolio volatility and reduce our directional exposure. That's especially true when you have a buy and hold portfolio which consists of long-term investment opportunities you want to own for a very long time, regardless of market sentiment. But when markets are at all-time highs and investors get extremely greedy (like the world we live in right now with no significant improvement in EPS estimates), even selling delta-neutral option strategies can turn into directional plays. Volatility is now very low, markets have posted a stellar performance so far in Q4 and last week, we started to skew our strangles to short delta to mitigate the impact of a sudden selloff.

It's always appropriate to stick to a contrarian view instead of chasing the market. It's far more interesting to remain non-emotional and add some short delta (while generating positive daily theta) when markets are euphoric instead of shorting the bottom. Adding short delta is also relative, which means that if the S&P-500 goes up by 1%, you don't want to lose that same 1% in one day. I'd rather want to be short 0.5-1 my daily theta number in this market. That means that if the market goes up by 1% and you collect 0.15% in daily theta, you lose 0.075%-0.15% because of short delta. However, when markets rally, volatility oftentimes decreases meaning you benefit from a contraction in an option's implied volatility. So adding short delta to an options portfolio doesn't have to be aggressive or way too directional or speculative, it's just a way of creating a natural hedge for our short strangles while collecting sufficient premium and leaving room to the upside.

And while our short deltas have weighed on our recent returns, we still generated a very nice time value return, though lagging the broader market is always painful. At least in the short term, as most people - especially these days - focus on return rather than risk-adjusted returns. I'd rather prefer the adage: winning by not losing via skewing our strangles on low-volatility stocks and collecting a steady daily cash flow.

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