What To Watch Out For In Option Strategies

Introduction

We believe that the real edge lies in high-probability option strategies, but the gap between choosing naked and covered positions is huge. Although covered and naked option selling theoretically have a similar probability of success i.e. win rate, there's one aspect we cannot overlook: the distribution graph and more specifically the tail risks. Let's take a look at the two different approaches. In this article, we also share great insights into our latest study on American Tower Corporation (AMT) and Crown Castle International (CCI) regarding buy and hold investing and in-the-money covered calls, excluding dividends.


High-Probability Strategies: ITM Covered Calls and Short Strangles

Whereas covered positions with an 80% probability of profit (in this article, we're going to talk about ITM covered calls) see small outcomes, the naked option selling strategies like short strangles and short straddles tend to see wide-ranging distributions in their returns.

Short Strangles

Theoretically speaking, a 1 SD short strangle with 45 days to expiration should have a probability of success of 68% (100% - 2 times 16%) . In reality, the average win rate considerably exceeds that threshold (about 84% at expiration without managing the trade throughout the cycle). Also, in the end, we are expected to make a decent profit on the trades (about $600 on an SPX strangle every single month). Without looking at the distribution graph, one would argue that a short strangle is a great strategy. However, the average and even the median along with the consistently high win rate are misleading.

(Source: Tasty Trade YouTube)

As one can notice from the graph provided above, the profits of short strangle trades over the past 15 years have been anything but normally distributed. In fact, they are gigantically negatively skewed. Since we cannot predict future stock market returns, short-term movements, future implied volatility, novice traders are at risk of interpreting the data incorrectly i.e. not paying enough attention to outlier moves.

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